Know why residual maturity is important in bond investments
Know why residual maturity is important in bond investments
There is a charm to investing in bonds and other fixed-income investments because they offer relatively lower risk and a source of steady income.
They are, therefore, a prudent choice for the savvy investor.
Predominantly investing in an array of debt instruments and fixed-income securities like Gilts, Treasury Bills, Corporate Bonds, and Money Market instruments, these funds offer a blend of security and returns.
Their allure lies in their ability to provide a minimum rate of interest over a specific period while maintaining a low-risk profile.
Yet, there is something every investor in a bond or any other debt instrument must know.
Understanding Fixed-income Securities
Fixed-income securities have a set point of maturity and, usually, a predetermined interest rate.
Typically, bond investments have a clear timeframe, and despite some being tradable in secondary markets, most require holding until maturity.
This long-term commitment makes it necessary for investors to understand the concept of residual maturity in evaluating these investments.
The importance of understanding this cannot be understated in times like now, when there is an expectation that interest rates will start declining hereon.
Maturity vs Duration
When discussing fixed-income instruments, 'maturity' and 'duration' are often used interchangeably, yet they hold distinct meanings in finance.
Maturity refers to the time until the principal is repaid.
For example, a five-year bond will earn interest for five years, with the principal returned at the end.
The maturity date, set at issuance, shortens as the time to this date decreases.
On the other hand, duration is a more nuanced concept, denoting a debt instrument's price sensitivity to interest rate changes.
It reflects the time an investor must wait to recover the bond's principal and interest payments.
The longer the duration, the higher the interest rate risk or reward.
Delving Deeper into Duration
Duration, a crucial investor metric, hinges on several factors like yield, coupon, and final maturity.
Essentially, the longer the duration, the more an investor waits for the return on their investment.
A higher duration also indicates a greater potential price fall if interest rates rise, and vice versa.
Consider the case of X, an investor weighing options in fixed-income instruments.
Anticipating a rise in interest rates over three years, X's choice hinges on the duration of the instruments.
X must decide between a 15-year bond with a 6% yield and a 10-year bond with a 3% yield, both priced at Rs. 1,000.
The 15-year bond offers Rs. 60 annually, returning the principal after 15 years.
The 10-year bond, however, yields Rs. 30 per year.
X realies that in a scenario of rising interest rates, the 10-year bond is more favourable as it loses less value compared to the 15-year bond.
Conversely, if interest rates fall, the longer-duration bond offers greater gains.
Importance of Residual Maturity
Residual maturity gives investors an insight into the remaining time for interest accrual and its impact on the bond's price.
Residual maturity is key in evaluating an instrument’s risk and potential return.
Securities with longer residual maturities generally pose higher risks and offer higher returns than those with shorter maturities.
This heightened risk and return are attributed to increased exposure to interest rates and market risks over a longer period.
Consequently, investors often seek higher returns for holding securities with extended residual maturities.
Additionally, the effect of residual maturity on a security's price is profound.
Securities with longer residual maturities tend to be priced higher than those with shorter ones because of longer exposure to interest rate and market risks.
Therefore, a higher price is usually demanded by investors for holding securities with longer residual maturities.
For investors, grasping the concept of residual maturity is vital for making informed decisions in their investment endeavors.
Understanding these concepts is vital for fixed-income investors aiming to make informed decisions.
By considering factors like residual maturity and duration, one can decide on which instrument to invest in based on financial goals and market outlook.
Sign-up to grow and conserve your wealth by investing in Bonds.
Follow us for nuggets that inspire you to win with wealth.