When you buy a bond, there’s a chance the borrower might not be able to pay you back, but bonds also carry a different kind of risk.
Duration, or interest rate risk, is related to a bond’s sensitivity to changes in interest rates.
When interest rates go up, you won’t be able to sell a bond for the price you paid, says Will Gornall, an associate professor at UBC’s Sauder School of Business.
“Because they’re traded, if you have a three percent bond and now the going rate is four percent, no one’s going to pay full price for your three percent bonds,” he explained.
“You have to sell it for a discount. That discount is what the duration risk is. It’s the risk that when interest rates go up, you won’t be able to sell this for the price you paid.”
Gornall says duration risk is the flip side of when you sign a fixed-rate mortgage and rates rise, but you are protected because you locked your rate in.
“When you’re lending money, of course, you’re on the opposite side of that trade,” he said.
Bonds are often seen as the safer part of a portfolio, but investors were given a painful reminder of duration risk in 2022, when central banks rapidly increased rates in a bid to fight inflation.
As interest rates rose, bond prices fell significantly, making the situation even worse for investors who also saw the equity portion of their portfolios take a hit that year—a double whammy to their investments.
For investors, the good news is that if the price of a bond you paid face value for drops because interest rates have risen, you only suffer a loss if you decide to sell it before it matures.
Andrew Clee, a vice-president at Fidelity Investments, said as long as the issuer doesn’t become insolvent you will get the bond’s face value back at maturity.
“But if you don’t intend to hold it to maturity, that can become a very real loss,” Clee said.
Duration risk is unrelated to the creditworthiness of the bond issuer. Even bonds issued by the government can take a hit when interest rates rise, despite the risk of default remaining low.
“Actually, interestingly enough, government bonds are often riskier in terms of duration risk than corporate bonds or other less safe bonds, simply because the less safe ones pay you more interest and usually they’re not so long term,” Gornall says.
“No one is going to be lending to a distressed company, to a company that might default, they won’t lend for 30 years at a low interest rate.”
To manage duration risk, active mangers of bond funds will vary the duration of the bonds they hold. If they think interest rates are going to rise, they will shorten the duration of the bonds in a portfolio to reduce its sensitivity to a rise in rates. However, if they think rates are going to fall, they could look to hold longer term bonds.
Clee says active bond managers who shortened the duration of the bonds in their portfolio in 2022 outperformed the passive market.
“I think there was a lot of complacency that kind of came out of the post-financial crisis era all the way through 2021 because we did have a very low interest rate and stable bond environment for a very long period of time,” he said.
Andrew Clee, a vice-president at Fidelity Investments, said as long as the issuer doesn’t become insolvent you will get the bond’s face value back at maturity.
“I think there was a lot of complacency that kind of came out of the post-financial crisis era all the way through 2021 because we did have a very low interest rate and stable bond environment for a very long period of time,” he said.
