What Does The Effective Duration Of A Bond Fund Indicate?

Investors in today’s market are all trying to avoid the same risks. One day’s gain might be erased by fifteen minutes of trading when the market opens the next day. Stocks may stop performing well and hardly show signs of weakness. During the last two years, even bonds have come into question. In the past, many investment advisors called bonds “low-risk investments.”

However, it quickly became evident when the markets faltered, that bonds were not risk free. With present proof—especially considering mortgage-backed bonds—investors must take caution in how they put their money to work, while not being paralyzed into inaction by the fear of losses. Bonds are safer than stocks.

Many factors influence the discrepancies between the safety of these investments. Bond funds are risky based on the duration to their maturity. Rising interest rates reduce the value of the bond and its coupon. The greater the duration, the more likely the risk for devaluation based on rising interest rates. Though this picture may seem simple enough, the total picture is complex.

Knowing what a bond fund’s effective duration is, will enable the investor to understand the risk of the investment. The bond fund duration is the period of time that the investor’s money is tied up in a bond: the effective date that the bond matures. In a ten-year bond with a low annual coupon, duration is high and the volatility of this investment bears greater risk. In the inverse scenario, the bond is relatively safe, though the pay-off may be considerably lower.

The bondholder desires interest rates to reduce. This action will result in higher yields for any bond. At the same time, certain actions help to keep the bondholder in control of his or her investment. The inverse relationship between bond yield and interest forms the axis point by which the investor needs to navigate.

In a stable market, where investors predict a lowering interest rate, bonds with low coupons and long durations can be taken advantage of for greatest yield. However, in economically stormy waters, bonds with high coupon yields and low durations make for the safest investment. The best practice for the investor is to keep his or her eye on future monetary flow.

Considering that each time a coupon is paid out the duration decreases, a bond that is purchased in a safe economy may fair well even if future monetary troubles arise. Though, no investor should count on a situation where a high-risk bond is purchased in the hopes that economic situations will revive, the opposite is safe enough for investors with a well diversified portfolio.