In terms of the following three empirical tendencies, discuss how they are relat

Question

In terms of the following three empirical tendencies, discuss how they are related to the concept of duraiton or sensitivity of the value of a secruity (or portfolio) to a change in market yields, and to the need that certain investors might have for the securing of a minimum yield over specified holding period (H), or portfolio immunization. In your analysis, discuss the concept that an immunized portfolio, under some specific simplifying assumptions, has a duration equal to the investor's desired holding period. Consider the duration of a zero coupon bond in your disccusion of immunization.

EmpiricalTendency1: A given change in yield to maturity affects the prices and rates of return of long-term more than short-term securities.

EmpiricalTendency2: Short-term yields normally flucuate more widely than long-term yields.

EmpiricalTendency3: Although long-term yields tend to cary les than short-term yields, the greater sensitivity of long-term prices to yield changes normally dominates relative price movements. That is, the prices of longer term securities normally undergo much greater changes than the prices of short temrs so that investors in long-term securities enjoy greater gains when yields fall and suffer greater losses when yields rise than do the holders of short-term securities.

Explanation / Answer

Answer

There is a common perception among many investors that bonds represent the safer part of a balanced portfolio and are less risky than stocks. While bonds have historically been less volatile than stocks over the long term, they are not without risk.

The most common and most easily understood risk associated with bonds is credit risk. Credit risk refers to the possibility that the company or government entity that issued a bond will default and be unable to pay back investors’ principal or make interest payments.

Bonds issued by the U.S. government generally have low credit risk. However, Treasury bonds (as well as other types of fixed income investments) are sensitive to interest rate risk, which refers to the possibility that a rise in interest rates will cause the value of the bonds to decline. Bond prices and interest rates move in opposite directions, so when interest rates fall, the value of fixed income investments rises, and when interest rates go up, they fall in value.

If rates rise and you sell your bond prior to its maturity date (the date on which your investment principal is scheduled to be returned to you), you could end up receiving less than what you paid for your bond. Similarly, if you own a bond fund or bond exchange traded fund (ETF), its net asset value will decline if interest rates rise. The degree to which values will fluctuate depends on several factors, including the maturity date and coupon rate on the bond or the bonds held by the fund or ETF.

Using a bond’s duration to gauge interest rate risk

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.

While no one can predict the future direction of interest rates, examining the “duration” of each bond, bond fund, or bond ETF you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates. Investment professionals rely on duration because it rolls-up several bond characteristics (such as maturity date, coupon payments, etc.) into a single number that gives a good indication of how sensitive a bond’s price is to interest rate changes. For example, if rates were to rise 1%, a bond or bond fund with a five-year average duration would likely lose approximately 5% of its value.

Duration is expressed in terms of years, but it is not the same thing as a bond’s maturity date. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond’s coupon rate. In the case of a zero-coupon bond, the bond’s remaining time to its maturity date is equal to its duration. When a coupon is added to the bond, however, the bond’s duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes.

Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.

Duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration.

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