Fixed Income Concepts: Yield Curve and Duration
The Yield Curve
An ideal way to illustrate the typical risk/return relationship for bonds is to look at the yield curve, which charts the maturities of bonds of the same credit quality and their corresponding interest rates. Longer-maturity bonds tend to be more volatile than shorter-term bonds, and investors are typically compensated for that risk in the form of higher yields. Thus the "normal" yield curve slopes upward (see below). During certain periods, short-term rates can be higher than long-term rates, however, resulting in the yield curve flattening or even inverting.
Duration
Duration measures a bond's sensitivity to changes in interest rates. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. The longer the bond has until maturity, the greater its duration. The longer a bond's duration, the more sensitive it is to changes in interest rates. Duration continually adjusts as coupon payments are made over the life of a bond.
An illustration of the relationship between interest rates, duration, and bond prices is provided below:
Related Resources
- iShares Market Perspectives (August 2011) - Preparing for Higher Interest Rates: When Will Rates Rise and What it Means for Investors Market Commentary: 10 pages
- iShares Fixed Income ETF Essentials Brochure: 4 pages
FAQs
- Q. What is the average yield to maturity?
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A. Yield to Maturity (YTM) is the discount rate that equates the present value of a bond's cash flows with its market price (including accrued interest). The Fund Average YTM is the weighted average of the fund's individual bonds holdings' YTMs based upon Net Asset Value ("NAV"). The measure does not include fees and expenses.
- Q. What is effective duration?
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A. Effective duration, like duration, measures the sensitivity of a bond's price to a change in interest rates. An effective duration of 2, for example, means that the price of the bond would decrease/increase by 2% if the interest rate increased/decreased by 1%.
Effective duration takes into account the embedded options within a bond to derive a realistic measure of the bond's interest rate sensitivity. For corporate and municipal bonds, the typical embedded option is a call option, which allows the issuer to call or pay off the bond should interest rates fall. For mortgage-backed, collateralized mortgage obligations and asset-backed securities, the embedded option consists of a prepayment option held by the borrower allowing for early payoff of the underlying loans. Because both call and prepayment options are held by the borrower, effective duration will in general be less than duration to stated maturity.
