Vanguard research May 2010

Distinguishing duration
from convexity
Authors
Donald G. Bennyhoff, CFA
Yan Zilbering
Executive summary. For equity investors, the perception of risk is
generally straightforward: Market riskthe possibility that prices may
move in an unprotable mannertends to be paramount. However,
for bond investors, dening risk is more complicated. Many important
risks that are specic to an individual bondsuch as default risk and
prepayment riskrequire consideration, but only interest rate risk is
systematic. Like market risk for stocks, interest rate risk is a universal
risk for bond investors, and the principal measure of interest rate risk is
modied duration (hereafter referred to simply as duration).
Because the topic of duration and a related conceptconvexitycan
be very complex, we offer this brief paper as a fundamental, rather than
a comprehensive, overview of the topic. Our goal is to help investors
understand why its important to consider both duration and convexity
when evaluating the interest rate risk of bonds.
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Understanding duration
Duration is a measure of the approximate sensitivity
of a non-callable bonds price to changes in interest
rates. For bonds with embedded optionssuch as
callable bonds, mortgage-backed securities (MBS),
and collateralized mortgage obligations (CMOs)
effective duration is generally the preferred measure.
Effective duration incorporates the terms for early
retirement for a bond. In other cases, such as
with Treasury Inflation-Protected Securities (TIPS),
duration reflects the sensitivity to a change in real
interest rates rather than nominal interest rates, as
with other bonds.
1
Specifically, duration is a way to estimate the
approximate percentage change in the price of a
bond for a 100-basis-point (1 percentage point)
change in interest rates. A bond with a duration
value of 4 would be expected to lose 4% of its
market value if interest rates rose by 100 basis
points. So why is duration measured in years? The
answer: Because duration is technically a weighted
average of the time to maturity of a bonds cash
flows. As such, it can help an investor assess how
soon an initial investment will be repaidtaking into
consideration not only when the principal should be
returned but also any interest payments that are due
along the way.
A bond is a loan from the bond holder or investor to
the bond issuer (for example, a corporation), so it is
only natural for investors concern to center on the
timely payment of interest and principal. The bonds
indenture, which is an agreement between the issuer
and investors, sets forth the specific terms of the
bond, including:
vhen will lhe bond nalure and principal
be repaid?
Can lhe principal be repaid prior lo lhe nalurily
date and, if so, at what price?
vhal inleresl rale (coupon will be paid lo lhe
bond owners?
How oflen will coupons be paid and is lhis rale
fixed or variable?
Two bonds with the same coupon rate and the same
stated maturity date can have different cash flow
patterns and hence different durations. For example,
one bond may pay interest more frequently than the
other. Duration can help an investor quantify how
these cash-flow differences may affect the value of
both bonds. For any given maturity date, higher cash
flows from a higher coupon rate result in a faster
payback period for the investor, hence a shorter
duration. A zero-coupon bond has a duration equal
to its remaining time to maturity. The duration of
a coupon bond, on the other hand, is shorter than
its time to maturitybecause the investor receives
periodic interest payments.
In addition to the timing of cash flows, inflation
matters because changes in interest rates are
frequently associated with changing trends for
economic growth and inflation. Higher-than-expected
inflation during the loan repayment period reduces
the purchasing power of both the principal at maturity
1 For more information on TIPS, see Investing in Treasury Inflation Protected Securities.
2
Duration: An example
A bond is trading at $10,000, the price at
which it was sold. If this bond has a duration
of 5 years, and if interest rates rise one full
percentage point, then the price of the bond
would be expected to fall by about 5% to
$9,500if everything else remains the same.
and the periodic interest payments, reducing the real
return. As a result, investors with longer-duration
loansthat is, holding longer-duration bondsare
more exposed to changes in interest rates than those
with shorter-duration loans.
Understanding convexity
Duration, however, captures only one aspect of
the relationship between bond prices and interest
rate changes. For larger interest rate moves, the
relationship between the change in rates and the
change in bond prices is asymmetric. The bond
price decrease resulting from a large interest rate
increase will generally be smaller than the price
increase resulting from an interest rate decline of
the same magnitude. This asymmetry arises from
the convex payoff pattern shown by the solid curved
line in Figure 1. This convex shape also means that a
portion of the interest rate move remains uncaptured
by duration.
Figure 1 plots the relationship between the price of
a bond and its yield. The dashed line approximates
the effect of a change in yield on the price of the
bond. Duration, a measure of interest rate risk, is
mathematically derived from the slope of this dashed
line. The curved line represents convexity.
Many bonds illustrate positive convexity and behave
in the manner illustrated in Figure 1. Convexity
captures the degree to which the actual bond price,
the solid curved line, deviates from the estimated
bond price, the dashed line, when the interest rate
changes. However, as shown by the dotted line in
Figure 2, on page 4, some bonds, such as callable
bonds and mortgage-backed securities, have negative
convexity at lower interest rate levels. This negative
convexity arises from the embedded options
discussed earlier: As interest rates fall, the investor
is more likely to receive his principal back early, i.e.
before maturity, shortening the life of the security
and making it less valuable from the standpoint
of total cash flow received. Thus, for a bond with
negative convexity, falling interest rates do not
significantly drive up the bonds price.
3
Duration versus convexity:
An illustration of the difference
Figure 1.
B
o
n
d

p
r
i
c
e
Notes: This figure is an illustration only and is not intended to represent
a specific mathematical relationship. Y
0
is the initial yield; Y
1
and Y
2
are
subsequent yields. P
0
is the initial price; P
1
is the price after the first
yield change and P
2
is the price after the second yield change.
Source: Vanguard.
p
2
y
2
y
1
y
0
p
1
p
0
Slope = p/y = Duration
y
p
Bond yield
Shaded area: Error in estimating
price changes using duration
increases with larger yield
changes because of convexity
4
As Figure 2 shows, duration is only an approximate
measure of interest rate risk because small and
large interest rate changes do not result in the
same percentage change in bond price. Because of
its linearity, in the absence of negative convexity,
duration will underestimate the actual price of a bond
for a given rate change. To obtain a more accurate
picture of the sensitivity of a bonds price to changes
in interest rates, its important to consider both
duration and convexity.
A real world example
Figures 3 and 4 illustrate the importance of
considering not only a bonds duration but also
ils convexily. ve show lwo proxies for a shorllo
intermediate-term duration portfoliothe Barclays
Capital U.S. GNMA Bond Index and the Barclays
Duration relative to yield change for two benchmarks: October 2007 through March 2010
Barclays Capital U.S. GNMA and U.S. 35 Year Treasury Bond Indexes
Figure 3.
Notes: GNMAs are represented by the Barclays Capital U.S. GNMA Bond Index, and Treasuries by the Barclays Capital U.S. 35 Year Treasury Bond Index.
Changes in yield, represented on the right vertical axis, are based on monthly data for the Barclays Capital U.S. 35 Year Treasury Bond Index. Over the
entire period, the cumulative change in yield for this index was a decrease of approximately 2 percentage points.
Sources: Barclays Capital and Vanguard.
35 Year U.S. Treasury
GNMA
Yield change
D
u
r
a
t
i
o
n
C
h
a
n
g
e

i
n

y
i
e
l
d

(
p
e
r
c
e
n
t
a
g
e

p
o
i
n
t
s
)
3
2
1
0
1
2
3
4
5
6
3
2
1
0
1
2
3
4
5
6
Mar. 31,
2010
Nov. 30,
2009
Jun. 30,
2009
Jan. 31,
2009
Aug. 31,
2008
Mar. 31,
2008
Oct. 31,
2007
Illustration of positive and negative convexity Figure 2.
B
o
n
d

p
r
i
c
e
Note: This figure is an illustration only and is not intended to represent
a specific mathematical relationship.
Source: Vanguard.
Bond yield
Bond with positive convexity
Bond with negative convexity
Past performance is no guarantee of future results. The performance of an index is not an exact
representation of any particular investment, as you cannot invest directly in an index.
5
Capital U.S. 35 Year Treasury Bond Index. Both
indexes include government securities and therefore
have similar credit ratings, and had similar durations
on the starting date. During the period from October
31, 2007, through March 31, 2010, the duration
of the GNMA portfolioas shown by the green
linewas significantly more volatile than that of the
Treasury portfolio even though the initial durations
were approximately the same. This difference in
duration is due in part to the negative convexity of
GNMA bonds:
As inleresl rales fell, fron Oclober 2007 lhrough
late 2008, the price of the GNMA portfolio
declined with rising expectations for mortgage
prepayments and lower mortgage interest
payments to the portfolio.
As inleresl rales increased fron lhe inlraperiod
lows in December 2008, the duration of the
GNMA portfolio increased (Figure 3), as did the
prices of the bonds in its portfolio (Figure 4).
n conlrasl, lhe duralion of lhe 3-5 Year Treasury
Index remained more stable, increasing slightly as
one would expect after rates fell (Figure 3).
vhen building bond porlfolios-whelher using
bond funds, exchange-traded funds (ETFs), or
individual bondsto help moderate interest rate
risk, investors need to be cognizant of both duration
and convexity. Its also important to understand the
practical limitations and nuances associated with
these measures.
Cumulative return relative to yield change for two benchmarks: October 2007 through March 2010
Barclays Capital U.S. GNMA and U.S. 35 Year Treasury Bond Indexes
Figure 4.
Notes: GNMAs are represented by the Barclays Capital U.S. GNMA Bond Index, and Treasuries by the Barclays Capital U.S. 35 Year Treasury Bond Index.
Changes in yield, represented on the right vertical axis, are based on monthly data for the Barclays Capital U.S. 35 Year Treasury Bond Index. For the
entire period, the cumulative change in yield for this index was a decrease of approximately 2 percentage points. The bond index values, represented on
the left vertical axis, are based on bond prices only (not total return including income).
Sources: Barclays Capital and Vanguard.
35 Year U.S. Treasury
GNMA
Yield change
B
o
n
d

i
n
d
e
x

v
a
l
u
e

(
p
r
i
c
e

o
n
l
y
)
C
h
a
n
g
e

i
n

y
i
e
l
d

(
p
e
r
c
e
n
t
a
g
e

p
o
i
n
t
s
)
3
2
1
0
1
2
3
4
5
6
94
96
98
100
102
104
106
108
110
112
Mar. 31,
2010
Nov. 30,
2009
Jun. 30,
2009
Jan. 31,
2009
Aug. 31,
2008
Mar. 31,
2008
Oct. 31,
2007
6
Reference
Vanguard Investment Counseling & Research, 2006.
Investing in Treasury Inflation Protected Securities.
Valley Forge, Pa.: The Vanguard Group.
Key terms
ConvexityA measure of a bonds actual price
change in response to an interest rate change,
compared with the estimated price change
based on duration alone. Convexity captures the
asymmetry in the relationship between bond
prices and interest rate changes, and is plotted
as a curved line.
Effective durationA duration measure that
takes into consideration any features that could
affect the maturity of the bond and the timing
of its cash flows. Such features would include
an issuers ability to call the bond, or retire it
before the maturity date.
Embedded optionA feature that is inseparable
from the bond itself. For example, if the bond
issuer has the right to call the bond after five
years, that is an embedded option in the bond.
Modified duration (duration) An indicator,
often stated in years, of the approximate
percentage change in the price of a bond for a
100-basis-point (1 percentage point) change in
interest rates. Duration is plotted as a straight line.
Zero-coupon bondA non-interest-bearing
bond that is sold at a deep discount from its face
or par value and is redeemed at par. Interest
is effectively being paid to the investor in the
form of the price appreciation of the bond as it
reaches maturity.
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