In the fund profiles above, we discuss average effective duration and average maturity. These core measures help investors understand the risks involved with a given fixed-income investment, specifically interest rate risks.
What Is Effective Duration?
Effective duration is a measure of the sensitivity of a bond or bond portfolio’s price to changes in interest rates. It takes into account not only the time to maturity but also the impact of cash flows like coupon payments.
In other words, effective duration considers how the bond’s price would change for every 1% change in interest rates, taking into account both the bond’s periodic interest payments and the final principal payment at maturity.
Like average maturity, effective duration is expressed as a number of years. Bonds with higher effective duration are more sensitive to interest rate changes and are likely to experience larger price fluctuations compared to bonds with lower effective duration.
What Is Average Maturity?
Average maturity, on the other hand, is a straightforward measure that represents the average time until the bonds in a portfolio or ETF mature and the principal is repaid. It does not consider the impact of cash flows or interest rate changes.
While average maturity can provide a general idea of the investment’s time horizon, it does not fully account for the potential impact of interest rate fluctuations on the bond’s price. Therefore, it may not be as reliable a measure of interest rate risk as effective duration.
What You Need to Know
Effective duration is a more sophisticated measure that reflects the sensitivity to interest rate changes, including cash flows. Meanwhile, average maturity is a simple average of bond maturities, not accounting for interest rate effects.
Investors and analysts often use both measures in combination to get a more comprehensive view of the interest rate risk associated with their bond investments.