Hear ‘bonds’ and multiple terms spring up in your mind. While the list of bond-related terminology is long, here we talk about the concept of modified duration. Among the most important factors affecting the price of a bond and its yield (return), are interest rates.

Bond yields and interest rates are inversely related. When interest rates rise or are expected to rise, it makes the earlier-issued bonds that are offering a lower coupon (fixed interest payment on a bond at regular intervals), less attractive. The new bonds, on the other hand, are more attractive as they offer a higher coupon rate, in line with the prevailing market interest rate. The price of the old bonds will therefore fall, making the yields go up.

But, what also matters is the extent of the interest rate impact. This can be assessed by modified duration, which is an indicator of the interest rate risk of a bond. For instance, if the modified duration is five years then as a thumb rule it means that for every one percentage change in interest rates, the return will be impacted by five per cent. Higher the modified duration, higher the interest rate sensitivity of a bond. If there are expectations of interest rates coming down, a higher duration helps to capture the maximum returns.

What impacts it? The modified duration of a bond is affected by its maturity and coupon. Higher the maturity and smaller the coupon, the higher will be the modified duration and greater will be its exposure to rate fluctuations.

Also, smaller the coupon, the longer it will take for you to substantially recover your investment in a bond. In the meanwhile, the value of your bond will be exposed to interest rates changes. On the other hand, if the coupon is higher, you will be able to recover a large part of your investment via coupon payments, and fluctuations in the value of your bond due to interest rate changes hurt you relatively less.

For an investor How do you make use of this concept? If you expect interest rates to rise, you can consider selling off the higher modified duration bonds in your portfolio to minimise your interest rate risk. For, it is the price of such bonds that will fall more sharply as rates rise. Conversely, if you are bearish on interest rates, then you can consider buying bonds with higher modified durations. This is because as rates fall, it is the price of these bonds that will rise more than that of bonds with smaller modified durations. In general, if you are risk-averse, you can invest in bonds with shorter durations to minimise your exposure to interest rate fluctuations.

You can check out the modified duration of a bond fund from its fact-sheet. Since a fund invests in several bonds of varying maturities, it will provide you the weighted average of the modified durations of different bond holdings.

comment COMMENT NOW