By Harrison Heaton
In times of inevitable changing interest rates, there has to be a concept and strategies in which the everyday investor can utilize to counteract the negative impacts of these interest rate hikes. Bond prices have an inverse relationship with interest rates, thus an investment portfolio for the individual investor is at the conditional hand of rate fluctuations. Duration measures how long it takes in years to repay the bond price through its cash flows while showing the exposure and susceptibility of bond prices to interest rate changes. This concept to fight back against these alterations of rates is known as duration matching, and aligns the inflow of assets against the outflow of liabilities. Anticipated returns are matched against the liability payments for a given time interval which give the best estimate of eliminating interest rate risks.
The process of matching durations includes matching exact asset cash flows with liabilities cash outflows for the same duration. Individuals alongside firms use this duration matching strategy against the adverse bounces of these interest rates. There is a very simple way to look at it. As a general rule and example, a 1% increase or decrease in interest rates will affect the bond price by either increasing it or decreasing it by 5% if the duration of the bond was 5 years, and 4% if the duration was 4 years, etc. For the individual investor, it is extremely important to acknowledge and know the foundation of duration matching when you are planning to sell your bond prior to the maturity date. Every bond or bond fund has a duration that is applicable to it, and when it comes to constructing and best adjusting your investment portfolio, a well versed understanding of duration and how it lays at the foundation of bond investing is absolutely vital. Financial managers and individual investors can use this knowledge to counterbalance longer term duration bonds with ones of shorter duration.
However, there are limitations to this seemingly bulletproof risk mitigation strategy. Probably the biggest issue this concept has ingrained in it is the assumption that interest rates and bond prices have a linear relationship. Yet, in fact, it has a more curvilinear shape with some convexity to it depending on the maturity date of the bond as mentioned earlier, and is only accurate for small shifts in interest rates that are equal in basis point alterations, however we know that interest rates don’t always change by the same amount every time. Additionally, a generic bond index can not completely replicate the unique cash flows that are present, and liabilities vary based on different factors and time frames. Meaning when it is trying to match the liabilities cash flow with the assets cash flows, you have to assume that liabilities may stay constant but more than likely this is not the case. To put the cherry on top, duration matching can be very costly to perform.
Alongside with all this being said, interest rate risk is never completely eliminated. There will always be some glimpses of risk, however duration matching is one of the main tools used to mitigate risk and gives the everyday investor that fighting chance they hope to achieve. Yet, when there are flaws present that make the accuracy skewed, there has to be adaptation to confront this. So, many managers and everyday investors within the bond securities industry evolved to use dollar duration matching, which attempts to match the dollar value change per basis point yield change for assets and liabilities. Simply put, it measures the dollar value change in the bonds value when faced with a change in market interest rates. When applying this mathematically, it measures the change in bond value for every 100 basis point change in the interest rate. Therefore allowing you to get to the exact dollar amount change when for example the FED increases rates by 100 basis points or 1 percent.
Now, I want to touch on a concept that underlies the entire duration matching purpose and essentially weighs out the severity of an interest rate fluctuation. This is the duration gap, or in better terminology, the difference between the weighted average duration of assets versus liabilities. This is a direct measure of the exposure risk individuals alongside financial institutions have based on their balance sheets. Duration matching tries to eliminate the gap or at least make it as close to 0 as possible, therefore interest rates don't affect the longer term duration assets or liabilities in a greater proportion than those of shorter term. In terms of financial institutions, assets usually have higher durations than the liabilities on the balance sheet making them more susceptible to risk. Yet, for the everyday investor this is not the case. Mortgages and loans comprise a great amount of the majority of the American citizens liabilities and usually has a longer term to pay it off, so when comparing the duration of assets to liabilities for the everyday individual investor, it seems to be the opposite of financial institutions making increases in interest rates proportionally affect individuals more, due to assets for individuals being shorter term.
Investing in bonds is looked at as a low risk low reward type of investment, however many successful entrepreneurs and investors take advantage of these securities due to the power they can give. Therefore, being able to invoke one, if not the most notable, risk management strategies towards your portfolio of bonds is huge and should be a basic standard before putting your money into them. Again, reiterating the fact that all it boils down to is the fact that you do not want interest rates affecting your liabilities and assets disproportionally because you can lose more money when they are. Duration matching the assets and liabilities benefits you as the investor due to making interest rates affect them nearly identically, and also allows a better opportunity to have your shorter term assets balance out with longer term liabilities making interest rates affect them less and putting more money in your pocket.
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Hayes, Adam. “Duration in Investing: How It Works, Types, and Strategy.” Investopedia, Investopedia, 22 Oct. 2021, https://www.investopedia.com/terms/d/duration.asp.
“Duration-Matching.” Duration Matching | Interest Rate Risk Management | Example, https://xplaind.com/379132/duration-matching.
Pimco. “PIMCO.” Pacific Investment Management Company LLC, PIMCO, https://global.pimco.com/en-gbl/resources/education/understanding-duration.
“Duration.” InvestingAnswers, https://investinganswers.com/dictionary/d/duration.
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