Interest Rate Risk — Duration

Interest rate risk is one of the most fundamental and at the same time most complex risks in institutional portfolio management. Changes in market interest rates directly affect the valuation of bonds, but also indirectly via effects on the stock market, property and other asset classes. A portfolio that is not actively managed with respect to interest rate risk can suffer unexpected and significant declines in value even if the underlying credits are solid.

Understanding and managing this risk is not only a precaution, but a prerequisite for achieving intended return targets over time.

Duration functions as a dimensionless measure that simplifies the complexity of interest rate risk. While duration gives an approximate estimate of how much a portfolio's value changes with a 1-percent change in the interest rate, it also captures nuances that a simple maturity measure misses. This includes the effect of coupon size and the current interest rate level, making it a more precise tool for comparisons between different bonds and portfolios.

For an institutional player, this is crucial in order to be able to create a portfolio with a predictable interest rate sensitivity that matches its risk appetite and investment horizon.

Beyond using duration as a passive measure, it can also be an active part of a management strategy. A manager who expects interest rates to fall can deliberately increase the portfolio's duration in order to maximize the potential value increase. This means selling short bonds and buying longer ones, or using derivatives to increase the effective duration.

This activity however requires a clear and consistent interest rate forecast. Duration can also be used to match a portfolio's interest rate sensitivity with a specific time frame, such as a pension fund's future payout source, a strategy known as duration matching.