Interest rate risk is one of the risks that fixed income investors need to be aware of. When rates increase, bond prices fall, as the coupon on the bonds will be less attractive to investors and they sell those bonds to buy new bonds with higher coupons. Exactly the opposite holds good in an environment of falling interest rates.
Duration is a measure to assess interest rate risks of the bonds. It measures the sensitivity of the price of a fixed-income investment to change in rates. All other things remaining same, higher the duration, higher is the interest rate risk of a bond. When interest rates rise, bonds with higher duration witness a higher fall in prices. Similarly, when interest rates decline, bonds with higher duration witness a higher gain in prices.
Macaulay Duration can be computed by taking the weighted average of various time periods of the cash flows (regular coupon payments and final principal payment) from the bond. The weight of each time period of cash flow is computed by dividing the present value of the cash flow received at the period by the price of the bond. The unit of this measure is number of years. For a zero coupon bond, duration is equal to its time to maturity as there are no intermediate coupon payments. For a vanilla bond, duration is lesser than its time to maturity.
In economic cycles, during the periods of recession or even a slowdown, the central banks of the countries follow accommodative monetary policy. They reduce the interest rates and/or purchase assets introducing liquidity into the markets. The asset purchases result in supply of money, driving prices higher and yields lower. As economy starts to recover and inflation starts to pick up, central banks start tightening the monetary policy. At times of tightening monetary regime, interest rates begin to climb and bond prices begin to fall. Even before the actual tightening begins, speculation and fear in the market can lead to market participants indulging in a sell off of the bonds. This would not only result in a fall in the market value of investments and capital losses, but also increase the borrowing rates for companies and institutions in a country. A sudden withdrawal of monetary stimulus can affect the growth prospects of the country.
The US Federal Reserve responded to the 2008 financial crisis through Quantitative Easing. The current round of Quantitative Easing, QE3, resulted in yields on US Treasuries declining. However, the markets are now concerned about a tapering of QE3 and the spreads on US Treasuries have widened. This has resulted in sell off in emerging market bonds.
The retail investors should know and understand the duration of the bonds that they purchase and the average duration of their portfolio of fixed income instruments. A financial advisor should be able to help retail investors in regularly assessing the duration of their portfolio of bonds.