Maturity, duration and yield
This animated tutorial explains maturity, duration and yield curves.
The second that a bond is issued it begins its journey towards the date that the issuer has promised to pay back the face value of the bond, or as it’s also known – its redemption date.
A bond may begin life as a long-dated bond of fifteen years or more and the term left to its redemption date is called its ‘term to maturity’.
Bonds with different terms to maturity react very differently to news and economic events in the market.
That’s because a bond’s value partly depends how much interest it has left to pay.
Let’s look at a simplified hypothetical example.
Say you had two bonds from the same issuer with identical par value and coupon rates, but different terms to maturity.
If you hold these bonds all the way to maturity, here’s what you’d get;
With bond one, you’d get five pounds per year over the course of ten years then get your capital back. Assuming you paid one hundred pounds, the total return of this bond is fifty pounds in income.
With bond two you’ll get five pounds per year over the course of two years then get your capital back. Assuming you paid one hundred pounds, the total return of this bond is ten pounds in income.
But remember, if you pay more or less than the one hundred pound face value of the bond, you will also make a loss or gain on that amount if you hold the bond to maturity.
So, what’s duration then?
Bond boffins use a lot of shorthand when talking about bonds, which can be a bit confusing. Usually, when they talk about ‘duration’ they mean a bond price’s sensitivity to changes in interest rates.
They’re talking about how much the price of a bond will change as a result of a given change in interest rates.
Simply put, the longer the duration of a bond, the more sensitive its price is to changes in interest rates.
Why? Because the change in the value of the bond that results from a change in interest rates is magnified by the number individual coupon payments left in the life of the bond.
A small change in interest rates would thus have a much smaller impact on the price of a bond with three years to run than on one with ten years left to run.
Bond boffins also talk a lot about yield curves. But what are these curves exactly?
They’re a graphical representation of yields of bonds of different maturities.
If you plot the yields of a series of bonds of the same type, say, UK government bonds, against their maturity it shows the relationship between yield and time.
Join the dots and you have a simple yield curve, the shape of which changes all that time.
This shape tells investors, economists, businesses, bankers and policy-makers a lot about what bond investors think about the future of an economy, base interest rates and/or inflation.
There are three basic shapes; normal, inverted and flat.
An upward sloping yield curve is called ‘normal’. This is because long-dated bonds often have higher yields than short-dated bonds.
This happens because longer-dated bonds are more exposed to the risk of changing interest rates or possible higher inflation.
It’s also because just as a bird in the hand is worth two in the bush, a pound in the hand today is worth more than the promise of a pound in the future due to the risk it will be worth less. So investors will normally demand a higher rate of interest to compensate for this uncertainty. This is what economists call ‘the time value of money’.
However, if investors think the economy is slowing the relationship between the market yield of long and short-term bonds can switch.
If this relationship changes enough that short-term yields are higher than long term yields, it’s called an ‘inverted yield curve’.
This is a fairly rare occurrence and its causes can be complex. Essentially, investors are demanding longer-term bonds as a safe haven during a slowing economy. This pushes prices up and yields down.
Inverted yield curves have often been correlated with the start of an economic recession.
A flat yield curve often reflects an economy, and a bond market, that is in transition between a recession and recovery.
The steeper the yield curve, the greater the gap between long and short-term yields. This in turn reflects the magnitude of the change expected by the market.
Yields change constantly in response to news about the economy, inflation and forward guidance offered by central banks.
As a result, the shape of the yield curve also changes constantly and often unpredictably. We’ll talk more about what causes this in a later module.
Investment risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
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This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
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