Jargon Buster

Jargon Busters




Average Portfolio Maturity and Duration



Bond and gilt funds are coming back into vogue – after a long dry spell of over 4 years. There was a time in the early part of this decade, when advisors sold only debt funds and concepts like average portfolio maturity and duration were closely tracked and hotly debated. What is duration and how is it different from average portfolio maturity? Why is duration a key parameter in deciding which fund is likely to perform better in a falling interest rate environment?



Generally, when interest rates fall, bond prices rise. A bond that has many more years to go before repayment of principal generally rises more that a short term bond, when interest rates fall.



A very basic example can illustrate why. Lets say you bought a 1 year Government security at par for Rs. 100 which pays out 10% interest at the end of the term. You now expect a cash inflow of Rs. 110 at the end of the term. Now, due to a change in market conditions, interest rates fall dramatically and the Government is now issuing 1 year paper at a 6% interest rate. If you were to sell your bond in the market, the buyer would expect a yield of 6%. The buyer will be willing to pay around Rs. 103 for your bond – as that is the price at which his yield would be approximately 6% - which is what he will get in the market today.



If on the other hand you had bought a 5 year zero-coupon bond from the Government which pays 10% interest (cumulative), you were expecting to get Rs. 161 from the Government at the end of your 5 year holding period. Now, the same situation happens and interest rates collapse to 6%. A buyer for this bond will now be willing to pay you around Rs. 120 for this bond – because that’s the price at which the yield works out to 6% - the current market yield.



As we can see, for the same rate of fall in interest rates (a simplistic case, no doubt), a longer dated bond’s price rises much more than a shorter dated bond’s price. But, as we will see below, it is not the tenure of the bond that matters – it is the maturity and duration that matter in determining its price.







Average Portfolio Maturity (APM)



If you bought a 5 year bond in the market 3 years after it was originally issued, there will be only 2 years left for the bond to mature. That is the maturity of the bond – and the maturity is far more relevant for a buyer because his cash flows will accrue over the next 2 years.

















































If you have a portfolio of bonds, each with its own maturity period, you will then calculate an average portfolio maturity (typically weighted by the individual amounts invested in each bond) to arrive at the APM of the portfolio.



A portfolio with a higher APM should normally rise more as a reaction to a reduction in interest rates, as compared to a portfolio with a lower APM. We saw in the simplistic example above, why this happens. That’s one reason why APM of a bond fund is closely tracked in a declining interest rate environment.





Duration



A higher APM is usually a good sign in a declining interest rate environment. But, is there a way one can estimate how much a fund’s NAV could rise for every 1% fall in interest rates? If you could estimate that, you will be able to decide which bond fund is best positioned to rally on a cut in interest rates.



This is where the concept of duration comes into play. Duration is calculated as the weighted average number of years to receive each cash flow in a bond. If a bond pays out interest every six months and is redeemed in say 4 equal annual instalments from years 7 to 10, it will have a smaller duration to a bond that is redeemed in a lumpsum at the end of 10 years, even if the interest is paid out semi-annually in the second bond as well. Why is this relevant to us? Because, duration of a financial asset measures the sensitivity of the asset’s price to interest rate movements. Therefore, duration of a bond fund portfolio can give you a good approximate of how much the NAV can appreciate for every 1% reduction in interest rates.



If a bond fund’s average duration is 4 years, and you expect a 2% reduction in interest rates, you can reasonably expect the NAV to appreciate by 4 times 2 --> 8% to reflect the 2% reduction in interest rates.



When you see fund fact sheets of bond and gilt funds, you will see both terms expressed : average portfolio maturity and duration. You will observe that duration is often far less than the APM expressed. That’s because each bond has different profiles of cash flows over the life of its residual maturity : all of which are captured in the term called duration.



Now, if you find two portfolios with identical APMs but the second has a higher duration and you expect interest rates to decline, which fund will you choose?