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For equity investors, the perception of risk is generally straightforward: Market risk-the possibility that prices may move in an unprofitable manner-tends to be paramount. However, for bond investors, defining risk is more complicated. Many important risks that are specific to an individual bond-such as default risk and prepayment risk-require consideration, but only interest rate risk is systematic.
Like market risk for stocks, interest rate risk is a universal risk for bond investors, and the principal measure of interest rate risk is modified duration (hereafter referred to simply as duration). Because the topic of duration and a related concept - convexity - can be very complex, we offer this brief paper as a fundamental, rather than a comprehensive, overview of the topic. Our goal is to help investors understand why it's important to consider both duration and convexity when evaluating the interest rate risk of bonds.

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from convexity

Vanguard research

**Executive summary. For equity investors, the perception of risk is
**

generally straightforward: Market risk—the possibility that prices may

move in an unproﬁtable manner—tends to be paramount. However,

for bond investors, deﬁning risk is more complicated. Many important

risks that are speciﬁc to an individual bond—such as default risk and

prepayment risk—require consideration, but only interest rate risk is

systematic. Like market risk for stocks, interest rate risk is a universal

risk for bond investors, and the principal measure of interest rate risk is

modiﬁed duration (hereafter referred to simply as duration).

Because the topic of duration and a related concept—convexity—can

be very complex, we offer this brief paper as a fundamental, rather than

a comprehensive, overview of the topic. Our goal is to help investors

understand why it’s important to consider both duration and convexity

when evaluating the interest rate risk of bonds.

**Connect with Vanguard > www.vanguard.com
**

> global.vanguard.com (non-U.S. investors)

May 2010

Authors

Donald G. Bennyhoff, CFA

Yan Zilbering

and collateralized mortgage obligations (CMOs)— effective duration is generally the preferred measure. and if interest rates rise one full percentage point. Effective duration incorporates the terms for early retirement for a bond. Duration can help an investor quantify how these cash-flow differences may affect the value of both bonds. A bond is a loan from the bond holder or investor to the bond issuer (for example. if so.1 Specifically. In addition to the timing of cash flows. In other cases. duration reflects the sensitivity to a change in real interest rates rather than nominal interest rates. on the other hand. is shorter than its time to maturity—because the investor receives periodic interest payments. A zero-coupon bond has a duration equal to its remaining time to maturity. then the price of the bond would be expected to fall by about 5% to $9. one bond may pay interest more frequently than the other. Duration: An example A bond is trading at $10. For example. hence a shorter duration.” 2 . For bonds with embedded options—such as callable bonds. at what price? s 7HATINTERESTRATECOUPON WILLBEPAIDTOTHE bond owners? s (OWOFTENWILLCOUPONSBEPAIDANDISTHISRATE fixed or variable? Two bonds with the same coupon rate and the same stated maturity date can have different cash flow patterns and hence different durations. so it is only natural for investors’ concern to center on the timely payment of interest and principal. inflation matters because changes in interest rates are frequently associated with changing trends for economic growth and inflation. a corporation). see “Investing in Treasury Inflation Protected Securities. higher cash flows from a higher coupon rate result in a faster payback period for the investor. duration is a way to estimate the approximate percentage change in the price of a bond for a 100-basis-point (1 percentage point) change in interest rates.Understanding duration Duration is a measure of the approximate sensitivity of a non-callable bond’s price to changes in interest rates. which is an agreement between the issuer and investors. For any given maturity date. The bond’s indenture. including: s 7HENWILLTHEBONDMATUREANDPRINCIPAL be repaid? s #ANTHEPRINCIPALBEREPAIDPRIORTOTHEMATURITY date and. Higher-than-expected inflation during the loan repayment period reduces the purchasing power of both the principal at maturity 1 For more information on TIPS.500—if everything else remains the same. mortgage-backed securities (MBS). as with other bonds. The duration of a coupon bond.000. such as with Treasury Inflation-Protected Securities (TIPS). If this bond has a duration of 5 years. it can help an investor assess how soon an initial investment will be repaid—taking into consideration not only when the principal should be returned but also any interest payments that are due along the way. A bond with a duration value of 4 would be expected to lose 4% of its market value if interest rates rose by 100 basis points. the price at which it was sold. sets forth the specific terms of the bond. As such. So why is duration measured in years? The answer: Because duration is technically a weighted average of the time to maturity of a bond’s cash flows.

shortening the life of the security and making it less valuable from the standpoint of total cash flow received. when the interest rate changes. Duration versus convexity: An illustration of the difference p1 p p0 y Slope = p/y = Duration y2 y1 y0 Bond yield Notes: This figure is an illustration only and is not intended to represent a specific mathematical relationship. P0 is the initial price. Many bonds illustrate positive convexity and behave in the manner illustrated in Figure 1. This convex shape also means that a portion of the interest rate move remains uncaptured by duration. before maturity. However. Y0 is the initial yield. deviates from the estimated bond price. a measure of interest rate risk. Understanding convexity Figure 1 plots the relationship between the price of a bond and its yield.e. Convexity captures the degree to which the actual bond price.and the periodic interest payments. P1 is the price after the first yield change and P2 is the price after the second yield change. For larger interest rate moves. for a bond with negative convexity. 3 . This negative convexity arises from the embedded options discussed earlier: As interest rates fall. such as callable Shaded area: Error in estimating price changes using duration increases with larger yield changes because of convexity p2 Bond price Duration. Y1 and Y2 are subsequent yields. bonds and mortgage-backed securities. however. The bond price decrease resulting from a large interest rate increase will generally be smaller than the price increase resulting from an interest rate decline of the same magnitude. Source: Vanguard. falling interest rates do not significantly drive up the bond’s price. the dashed line. The curved line represents convexity. the investor is more likely to receive his principal back early. have negative convexity at lower interest rate levels. Thus. Figure 1. on page 4. holding longer-duration bonds—are more exposed to changes in interest rates than those with shorter-duration loans. investors with longer-duration loans—that is. some bonds. captures only one aspect of the relationship between bond prices and interest rate changes. as shown by the dotted line in Figure 2. Duration. This asymmetry arises from the convex payoff pattern shown by the solid curved line in Figure 1. is mathematically derived from the slope of this dashed line. the solid curved line. As a result. The dashed line approximates the effect of a change in yield on the price of the bond. the relationship between the change in rates and the change in bond prices is asymmetric. reducing the real return. i.

Sources: Barclays Capital and Vanguard. To obtain a more accurate picture of the sensitivity of a bond’s price to changes in interest rates. 2007 Mar. 2009 –3 Mar. are based on monthly data for the Barclays Capital U. Source: Vanguard. 31. 31. duration is only an approximate measure of interest rate risk because small and large interest rate changes do not result in the same percentage change in bond price. it’s important to consider both duration and convexity.S. 2009 Jun. GNMA Bond Index and the Barclays Bond yield Note: This figure is an illustration only and is not intended to represent a specific mathematical relationship. 31. 2009 Nov.S. GNMA and U. in the absence of negative convexity. Duration relative to yield change for two benchmarks: October 2007 through March 2010 6 6 5 5 4 4 3 3 2 2 1 1 0 0 –1 –1 –2 –2 –3 Oct. 31. Over the entire period. Illustration of positive and negative convexity Bond price Bond with positive convexity Bond with negative convexity A real world example Figures 3 and 4 illustrate the importance of considering not only a bond’s duration but also ITSCONVEXITY7ESHOWTWOPROXIESFORASHORT TO intermediate-term duration portfolio—the Barclays Capital U. the cumulative change in yield for this index was a decrease of approximately 2 percentage points. duration will underestimate the actual price of a bond for a given rate change. 30. and Treasuries by the Barclays Capital U. As Figure 2 shows. 4 Change in yield (percentage points) Duration Barclays Capital U. 2008 Aug.S.S.Figure 2. 2008 Jan.S. 3–5 Year Treasury Bond Index. Because of its linearity. Past performance is no guarantee of future results. Figure 3. 3–5 Year Treasury Bond Index. 3–5 Year Treasury Bond Indexes . represented on the right vertical axis. 2010 3–5 Year U. Treasury GNMA Yield change Notes: GNMAs are represented by the Barclays Capital U.S. GNMA Bond Index.S. The performance of an index is not an exact representation of any particular investment. 30. Changes in yield. 31. as you cannot invest directly in an index.

through March 31. The bond index values. 2010. the cumulative change in yield for this index was a decrease of approximately 2 percentage points. 2007 Mar. represented on the left vertical axis. 2009 Jun. 31.S. 3–5 Year Treasury Bond Index. 31. and had similar durations on the starting date. are based on bond prices only (not total return including income). Both indexes include government securities and therefore have similar credit ratings. 3–5 Year Treasury Bond Index. Capital U. 3–5 Year Treasury Bond Indexes –3 Mar.S. Cumulative return relative to yield change for two benchmarks: October 2007 through March 2010 112 6 110 5 108 4 106 3 104 2 102 1 100 0 98 –1 96 –2 94 Oct.S. 2009 Nov. For the entire period.S. 31. 31. Sources: Barclays Capital and Vanguard. Changes in yield. 2008 Aug. 31.Figure 4. 2007. During the period from October 31. GNMA Bond Index. the duration of the GNMA portfolio—as shown by the green line—was significantly more volatile than that of the Treasury portfolio even though the initial durations were approximately the same. 2008 Jan.S. GNMA and U. and Treasuries by the Barclays Capital U. 3–5 Year Treasury Bond Index. are based on monthly data for the Barclays Capital U. 2010 3–5 Year U.S. Treasury GNMA Yield change Notes: GNMAs are represented by the Barclays Capital U. 30. 30. represented on the right vertical axis.S. This difference in duration is due in part to the negative convexity of GNMA bonds: s !SINTERESTRATESFELL. 2009 Change in yield (percentage points) Bond index value (price only) Barclays Capital U.

s )NCONTRAST. the price of the GNMA portfolio declined with rising expectations for mortgage prepayments and lower mortgage interest payments to the portfolio. as did the prices of the bonds in its portfolio (Figure 4).FROM/CTOBERTHROUGH late 2008. s !SINTERESTRATESINCREASEDFROMTHEINTRA PERIOD lows in December 2008. the duration of the GNMA portfolio increased (Figure 3).

5 . investors need to be cognizant of both duration and convexity. or individual bonds—to help moderate interest rate risk. 7HENBUILDINGBONDPORTFOLIOSWHETHERUSING bond funds. increasing slightly as one would expect after rates fell (Figure 3).THEDURATIONOFTHEn9EAR4REASURY Index remained more stable. It’s also important to understand the practical limitations and nuances associated with these measures. exchange-traded funds (ETFs).

Investing in Treasury Inflation Protected Securities. or retire it before the maturity date. Key terms Convexity—A measure of a bond’s actual price change in response to an interest rate change. For example. Effective duration —A duration measure that takes into consideration any features that could affect the maturity of the bond and the timing of its cash flows. 6 . Modified duration (duration) —An indicator. Duration is plotted as a straight line.Reference Vanguard Investment Counseling & Research. Interest is effectively being paid to the investor in the form of the price appreciation of the bond as it reaches maturity. Zero-coupon bond—A non-interest-bearing bond that is sold at a deep discount from its face or par value and is redeemed at par.: The Vanguard Group. that is an embedded option in the bond. Convexity captures the asymmetry in the relationship between bond prices and interest rate changes. Pa. 2006. often stated in years. and is plotted as a curved line. compared with the estimated price change based on duration alone. if the bond issuer has the right to call the bond after five years. Valley Forge. Such features would include an issuer’s ability to “call” the bond. of the approximate percentage change in the price of a bond for a 100-basis-point (1 percentage point) change in interest rates. Embedded option —A feature that is inseparable from the bond itself.

investors) Vanguard research > Vanguard Center for Retirement Research Vanguard Investment Counseling & Research Vanguard Investment Strategy Group E-mail > research@vanguard. Inc. Box 2600 Valley Forge. ICRDDC 052010 . All rights reserved.S.com (non-U.O.vanguard.com CFA® is a trademark owned by CFA Institute.vanguard. PA 19482-2600 Connect with Vanguard® > www. © 2010 The Vanguard Group.P.com > global.

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