The volatility of the current market has driven some investors out of stocks and into bonds, which are often perceived to be less risky.
But bonds also have risks – most notably, interest-rate risk. This risk, however, can be managed if you understand the concept of duration.
Generally speaking, bond prices move in the opposite direction of interest rates. Higher interest rates drive bond prices down and vice versa. The risk that your bond price will fall because interest rates rise is called interest-rate risk.
When purchasing shares of a bond fund, you can help manage interest-rate risk by paying attention to the fund’s duration. Duration is a number that indicates the percentage change in the price of a bond fund for each 1% change in the interest rate.
For example, if the bonds in a particular fund have an average duration of three years, for each 1% change in interest rates, the bond fund’s price should move 3% in the opposite direction of the interest-rate change. The lower the average duration of a bond fund, the less price sensitivity the bond should experience.
What does this mean for you?
If you are a risk-averse investor, you may want to consider bond funds with shorter durations. In the event that interest rates rise (and prices drop), you don’t want to be “locked in” to bonds that don’t mature for several years. With rising interest rates, bonds with longer durations will actually be worth less than newly purchased bonds.
If, however, you purchase faster-maturing bonds – those with shorter durations – you’ll be able to replace the lower-price bonds as they mature.
Many investors are concerned about what to invest in given the volatile market.
While bonds remain good investments, you can minimize the risk by understanding the concept of duration and making it work for your individual situation.