Understanding Key Rate Duration: Boost Your Investment Strategy π
Key rate duration measures how the value of a debt security or a debt instrument portfolio, generally bonds, changes at a specific maturity point along the entirety of the yield curve. By examining this metric, investors can determine the sensitivity in a debt security’s price to a 1% change in yield for a specific maturity while keeping other maturities constant.
Key Takeaways π
- Precision Measurement: Key rate duration calculates the change in a bond’s price relative to a 100-basis-point (1%) change in yield for a specified maturity.
- Yield Curve Dynamics: Effective duration works for parallel yield curve shifts, while key rate duration is crucial for non-parallel movements, providing a detailed estimate of portfolio value changes.
- Risk Assessment: Duration metrics highlight the price risk involved in holding fixed-income securities, considering interest rate changes.
How to Calculate Key Rate Duration π
KRD = (P- β P+)/ (2 Γ Ξy Γ P0)
Where:
- P- = Security’s price after a 1% decrease in its yield
- P+ = Security’s price after a 1% increase in its yield
- P0 = Security’s original price
Example Calculation π
Imagine a bond originally priced at $1,000. If a 1% yield increase results in a new price of $970, and a 1% yield decrease leads to a price of $1,040, the key rate duration can be calculated as follows:
1KRD = ($1,040 - $970) / (2 Γ 1% Γ $1,000) = $70 / $20 = 3.5
What Does Key Rate Duration Reveal? π‘
Key rate duration is an essential tool for investors seeking to understand how bonds or bond portfolios will evolve when the yield curve experiences non-parallel shifts, which often occur in the market.
Unlike effective duration, which only accounts for parallel shifts, key rate duration dissects the yield curve at distinct maturity points, providing a thorough analysis. Notably, there are 11 distinct key rate durations corresponding to various maturities along the Treasury spot rate curve, and their aggregate gives the effective duration of a portfolio.
Applying Key Rate Duration: A Closer Look at Strategy π―
Comparative Example π
Understanding individual key rate durations can be challenging since itβs rare for one point on the yield curve to shift in isolation. Examining the key rate durations across the curve offers insights into relative values between securities.
For example:
- Bond X: One-year key rate duration of 0.5, five-year key rate duration of 0.9.
- Bond Y: One-year key rate duration of 1.2, five-year key rate duration of 0.3.
From this, Bond X is observed to be half as sensitive as Bond Y at the short-term end, whereas Bond Y is less sensitive by one-third to mid-term rate changes.
Related Terms: Effective duration, yield curve, debt security, interest rate risk, spot rate.
