In any analysis of fixed income (or liabilities), it is important to measure the "duration" of the income (or liability) stream. Duration is the cash-flow adjusted effective term to maturity for a series of given cash flows. Thus, duration is also sometimes referred to as "effective maturity." It is also important to know that the duration of a portfolio of assets (or liabilities) is equal to the weighted average duration of the underlying assets (or liabilities). In addition, the higher the duration of a series of cash flows, the greater its sensitivity to a change in interest rates.
There are a variety of ways to calculate duration that are beyond the scope of this brief; however, most involve either a simple calculation heuristic or an automated spreadsheet. Either way, there is a very important benefit of knowing the duration of a series of cash flows. A bondholder that holds (and reinvests the coupons of) a bond to its duration is effectively "immunized" from interest rate changes and should experience a holding period yield (HPY) that is approximately equivalent to the original yield to maturity on the bond.
Of course, there are several assumptions (e.g., the bond issuer does not default, etc). However, in the base case, this notion can be very valuable to an investment manager that needs a certain cash flow at a certain date and time. This is often the case for endowments that have payout requirements or pensions that have retirement obligations.
If an investment manager can calculate the duration of its assets and the duration of its liabilities, it can make a determination as to the interest rate sensitivity of the portfolio; and thus estimate its ability to meet its future obligations. For example, if the duration of the portfolio assets is greater than the duration of the portfolio liabilities, then the portfolio structure is susceptible to rising interest rates.
This is because the higher duration assets are more sensitive to interest rates than the lower duration liabilities. Should interest rates rise, the assets will decline in value more quickly than the liabilities will. If interest rates remain at that level, there may be a shortfall in funding the liabilities.
One way to mitigate this problem is to rebalance the asset portfolio such that the duration of the assets is equal to the duration of the liabilities, such that any interest rate change has a negligible effect. If, in the case above, the asset portfolio duration is too high, the duration must be reduced.
This reduction may be accomplished by either rebalancing the portfolio with shorter duration assets (e.g., shorter term Treasuries or even cash) or by shorting longer duration assets. The zero coupon market in Treasuries (STRIPS) is often used due to the unique result that zero coupon bonds have durations that are exactly equivalent to their maturities.
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