Coupon bond duration: how to determine the investment payback period
Coupon bond duration is an important point in an investor’s work. This concept represents a certain period of time during which it will be possible to return the funds invested in securities. The calculation takes into account the periodicity of payments, the volume of coupon profits, which gives each bond. To determine this period, various online services are used.
To put it simply, the higher the duration, the faster the investor will be able to repay the funds invested in bonds. The lower the level of this indicator, the more time will be spent on redemption. This way you can know the payback period and risk level.
Using this tool, it is possible to determine the average payback period of investments, to study the possibility of investing in other financial assets, which differ in fixed payments. Banks use duration to evaluate credit products.
Macaulay’s formula is used to determine the duration of a coupon bond, resulting in an optimal payback period. In the analysis, each payment is taken into account over time, when it will be identified through discounting. The formula takes two main indicators – the sum of weighted contributions and the market value of the bond, the first value is divided by the second. In addition, the Macaulay formula shows other parameters that take into account the volatility of the price of paper.
Perpetual bonds are the best investment solution if the investor wants to earn income for a long time. These securities do not require repayment, but only give the right to receive profit on coupons. However, there are cases when perpetual bonds have a duration of 10 years. It means that after that period the paper will be forcibly repaid.
Most often, modified duration is used. It shows how the value of the bond changes as a percentage when interest rates change.
From the point of view of investment, papers with a lower level of duration will be attractive. They are not so risky, and show good dynamics of the money flow, so we can hope for more profit when investing again. A high level of risk is observed in case of zero-coupon bonds where the income is paid out once and there are no interim payments.
By estimating the ROI period, an investor can understand how much he or she risks, and how different factors will affect the timing of the return on investment. Duration takes into account the discount rate, where its rate is the Central Bank’s discount rate, on which fluctuations in bond value depend. At a high level of duration, fluctuations in the rate of discounting payments are more strongly influenced by fluctuations in the rate of discounting payments. This results in the securities being more susceptible to changes in market indicators.
