Calculating the yield to maturity of a bond automatically assumes that the investor is reinvesting periodic interest payments, known as coupon payments, at the same rate of interest the bond earns. This is an almost impossible realization. Therefore, many investors, brokers and portfolio managers use duration to account for volatility in the market and to determine the actual time it takes to recover the true costs of investing in the bond. While you cannot change a bond's actual duration, you can make changes that reduce your risks related to duration.
Reduce the length of time until a bond matures. Interest rate risk, or the risk of fluctuations in interest rates, increases over a longer period of time. Coupon payments are also subject to a greater risk of inflation over an increased time until maturity. Therefore, a shorter time until maturity will cause the duration to decrease.
Purchase bonds with higher coupon payments. A higher coupon payment reduces the chances that inflation will erode purchasing power. Purchasing power represents the amount of goods that you can purchase with a fixed amount of money. Over time, this amount decreases.
Attempt to reinvest coupon payments at a higher rate. Earning a greater amount of interest or return than the bond's coupon payments will increase yield to maturity and decrease duration. If an investor can earn more on his returns, he is better able to offset the costs of investment and does not need to produce as great a return in the future. This does not shorten the actual duration of the bond but reduces the amount you need to earn to recover the costs.
Sell your bond when it appears interest rates will decrease or when market rates fall slightly below the coupon rate of your bond. You will be able to sell your bond at a premium, increasing your yield. Another person will inherit the bond's duration upon purchase and you can buy a bond with a shorter length of time until maturity.
Invest in a bond fund. The shorter duration of some of the bonds held within the fund will offset those with a longer duration.
Do research on any bond before purchasing it and review market interest rates over the past couple of years. You should not purchase a bond that has a lower-than-market rate if you feel market rates will increase soon.
Duration can be a tricky concept for many investors to understand. Make sure you comprehend the concept before using it as a gauge for bond purchases.
- Duration can be a tricky concept for many investors to understand. Make sure you comprehend the concept before using it as a gauge for bond purchases.
- Do research on any bond before purchasing it and review market interest rates over the past couple of years. You should not purchase a bond that has a lower-than-market rate if you feel market rates will increase soon.
- "Fundamentals of Investing"; Lawrence Gitman, et al.; 2011
- Morningstar: Bonds 101 -- Bond Duration