Bonds Part IV: Bond duration 5 years vs 10 years vs 15 years

Under most circumstances the farther is the maturity date, higher is the interest rate one receives on the bonds. However often one does not have such a long investment horizon. In that case should one forego the extra interest in order to match the term date or should one go for the extra interest and hope that he/she would be able to sell the bond off at a profit?

1. If you believe that the interest rate would fall in the future, then go for the longer duration bonds. This way you can capture the maximum value.
2. If you believe that there will not be sufficient liquidity on your bonds or the credit rating of the issuer might deteriorate over time then go for the right duration only (in fact I might even go for a shorter duration)
3. If you are not into trading and know when you would need your money back then this simple calculation can be of use.

Eg: IFCI was the last firm to issue bonds. It offered 2 options 10.5% on a 10 year bond and 10.75% on a 15 year bond. For simplicity let me assume that it is a cumulative bond.

So a 15 year bond would mature at 46,255/- (10,000/- face value)

While a 10 year bond would mature at 27,141/-. So by keeping the money for 5 additional years, you can multiply your money by (46/27) = 1.7 times. 11.25% interest (compounded annually) for the remainder 5 years. (Similar computations can be done for coupon bearing bonds but it would require some excel work)

I know in this example I am fiddling with the 8th wonder of the world (Power of Financial Compounding), but you get the gist. One might think that an extra 25 basis points might not be too big an enticement to lock oneself into a 15 year term. However if you do an incremental analysis, that 25 basis points become 75 basis points. This is something worth considering. Also it would provide certain protection in case the interest rates go up. (however remember you are not completely hedged, and can incur a loss if the interest rate goes up too much)

What is more interesting is that in case of bonds with put option, longer duration bonds tend to have a different put schedule. So if the interest rates goes down substantially then the put option would be exercised later hence giving you a chance to make the most of the situation.

Gist: If the interest rates stay the same/move downwards, then its best to go for a longer duration bond (provided it has liquidity) else try to match the duration with your investment cycle.

 

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