The Effects of Maturity and Duration on Your Bond

A bond's duration is a measure of its value over time. The more fluctuation there is in a bond's duration, the riskier the bond is. Bonds with durations that do not fluctuate represent stable returns over time. Duration is tied into maturity, or the length of a bond. Bonds with longer maturity periods may have more price fluctuations, but their duration should not be affected unless they are higher risk bonds. The major factors to consider when determining duration are price and yield.

Price of a Bond

The price of your bond is based on the relative risk of the bond. Riskier bonds tend to be cheaper, leaving more room for high returns that could make the risk worthwhile. Stable bonds tend to be less expensive comparatively. Over the time you hold the bond (i.e., its maturity), the price of new bonds issued by the same organization will fluctuate. If the price goes down, your bond will be worth less, lowering your potential return if you sell. If the price goes up, you will make a profit by selling. Bond price does not exist in this simple bubble, though; yield is also a factor.

Yield of a Bond

The yield of a bond, or its interest paid each term, will also fluctuate during the time before it matures. The yield of the bond you personally hold will remain constant, but new bonds issued by the organization may be different. If the yield of the bond goes up, your bond will not be as valuable if the price remains the same. An investor could buy the same bond at the same price with a higher yield. If the yield of newly issued bonds is lower, though, yours may be more attractive for an investor looking to buy.

Calculating Duration

Price and yield are always working in conjunction with each other to determine the actual value of a bond. For example, if the bond you purchased for $50 at a 5 percent yield is now being issued $40, you may think you will lose money if you sell. However, the new bond may be issued at only 3 percent, which means an investor may still pay the $50 for your bond or even more in order to capture the higher yields. This comparison of price and yield is called duration. You can track a bond's duration before purchase in order to determine if the duration is steady or fluctuates.

Duration vs. Maturity

Considering duration of a bond gives you a better picture than considering price or yield alone. However, another element comes into play when maturity is considered. Bonds that are held for a longer period of time are often exposed to more risks, including the risk of high inflation. If inflation goes up while a bond matures, the rate of inflation will be deducted from the interest on the bond to find a realistic calculation of earnings. Therefore, duration needs to be tracked in comparison to how long a bond is held. A long bond must have a much more favorable duration in order to be worth the increased exposure to risk.

blog comments powered by Disqus