Understanding bond duration and interest rate risk

With the recent changes in the Reserve Bank of India’s repo rate and stance on inflation, there has been a significant rise in interest rates. The current repo rate stands at 5.90%, and the market is already expecting another hike in the following months. While the equity market has endured tremendous volatility due to these movements, one definite beneficiary here has been the bond market. Worried about market uncertainties, many of you might be turning towards the comparatively safer bond market. The higher yield on offer is another reason triggering this movement. If you are also keen on allocating a larger part of your portfolio to bonds, it is imperative that you understand bond duration and the corresponding interest rate risk.

What is bond duration?

The term bond duration can easily be confused with the bond’s time to maturity, which is the due date for the repayment of the principal amount that you have invested. For a 10-year bond issued today, the time to maturity would be 10 years. However, bond duration refers to the period required, in years, for your invested amount to be repaid through the total cash flows arising from the investment. Since bond duration tracks the cash flows linked to the investment, it is strongly impacted by interest rates and this is where the interest rate risk makes an entry.

Importance of bond duration

Historically, it has been noticed that, when the bond duration is higher, its price will drop in line with an increase in interest rates, leading to a greater interest rate risk. This is because you, as an investor, would be keen to recoup the investment as early as possible. In this scenario, bonds which take longer to repay your investment, would have a lower demand. Therefore, when you consider investing in bonds, in a high interest regime, it is important to look for papers with a low duration and, thereby, a lower interest rate risk.

The bond’s duration could be affected by a variety of factors, including the time to maturity and the coupon rate. The longer the maturity of the bond, the higher its duration will be. And, with the higher duration, comes a higher interest rate risk. This is because, a bond which is issued with a maturity of 1 year, would repay its true cost much sooner than a bond with 10-year maturity. Accordingly, your interest rate risk would also be limited to one year, rather than the much longer duration of 10 years. In terms of coupon rate, a bond with a higher coupon would be able to repay you sooner than the alternative. Therefore, when the coupon rate is higher, the bond’s duration, and thereby, the underlying interest rate risk, would be lower.

Since a bond’s duration helps you calculate the amount of risk you are taking on, it enables you to take better decisions. For instance, in the current scenario, if you invest in a one-year bond, your bond duration and interest rate risk would be lower since there are comparatively lower chances of the interest rate regime changing drastically. However, over the next five years, your bond investment may come under higher risk, following unexpected interest rate movements. Knowing these aspects will enable you to take the right decision, in line with your investment goals and return requirements. Once you have clarity in these aspects, you can go ahead and pick the bond investment most suitable for you. Alternatively, you can also invest in debt mutual funds, in a maturity of your preference. Bond investments are popular again, thanks to their safe nature as well as the higher yield being offered.   

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