What is duration?
In the financial sector, the term duration usually arises in connection with bonds or bond funds and is particularly important in this context, because yields and prices of bonds and bond funds move in opposite directions. Usually, this refers to the so-called modified duration, one of the most important key figures in the daily handling of bonds.
Duration as a measure of risk
Modified duration provides information on the relative change in the bond price depending on a change in market interest rates.
It therefore indicates by what percentage a fixed-income security falls when the market interest rate level rises by one percentage point.
Modified duration therefore measures the price effect triggered by a marginal change in interest rates. This allows the interest rate risk of a bond to be estimated.
Crucially, in this case, a higher duration can be accompanied by greater price fluctuations and therefore also a higher interest rate risk.
According to ETF provider Lyxor (as of 31 March 2020), the duration for the Lyxor EuroMTS Highest Rated Macro-Weighted Govt Bond 3-5Y (DR) UCITS ETF is 3.84 years, for example. This means that the price of the ETF would fall by 3.84% if, on the other hand, market interest rates were to rise by one percentage point.
With a shorter duration, the price value in the example above would consequently fall less sharply. With a longer duration, the price would fluctuate more.
Duration is essentially influenced by three factors:
Bond term: The longer the term, the greater the duration
Coupon rate: The higher the coupon, the lower the duration
Market interest rate: When the market interest rate rises, the duration falls
Duration using the example of a government bond with a term of 100 years
For a few years now, the phenomenon of “ultra-long bonds” has existed on the bond market. These are bonds with a term of more than 30 years.
In fact, because of low interest rates, more and more countries are exploring whether to issue 50-year or even 100-year government bonds.
In September 2017, for instance, Austria decided to take advantage of the already low interest rate level at the time to issue a bond with a 100-year term (maturity: 20 September 2117).
But other countries such as Argentina, Mexico, Italy or France have also already issued so-called “ultra-long government bonds”.
Investors who up until then had often had to accept negative yields with European government bonds found these bonds came just at the right time.
Ultimately, the low yields on high-quality (government) bonds force many investors to invest in bonds with a poorer credit rating in order to still generate an acceptable return.
Moreover, as is to be expected, the duration of the aforementioned centenary bond from the Alpine republic is very high. The modified duration is 53.25 (as of 21 April 2020).
Consequently, the government bond would be particularly heavily affected by a change in interest rates. The interest rate risk would therefore be very high.