You need to get an intuitive sense of what "bond duration" is... Draw a rough diagram of bond cashflows (including the redemption) and try to think about duration as a sort of "center of gravity" of the resulting jaggedy structure. Then imagine what happens if the bond has a higher coupon. Let me know how you get on.
Martinghoul, Your name popped up in a few google searches relating to the Treasury Yield Curve papers by Solly Bros. LOL Regarding those papers, it isn't something easy for an amateur like myself but it seems rich in content. Do you have suggestions on cash flow analysis? Perhaps I need to look at this again. UGGH.. From what I gather, the general sense is that it's literally a way to measure price volatility in relations to interest rates? But by definition, bond duration seems a bit confusing (at least to me). Essentially duration looks at the re-investments of the coupons during the cash flow life in relations to current interest rates at the time? If I had a 10% BOND which I paid $900 for and rates starts to increase to 15%, my duration shortens because my coupon can now be invested at 15%? At a higher rate, I can recover my initial $900 investment? Hence my duration is shorter as I am able to 'recover' the $900? Hmm...
No, forget the whole re-investment stuff for now. Just think about what bond cashflows look like and what higher coupons mean etc. Draw a simple diagram, do a few simple calculations in Excel and you will see the light.
I have seen examples and formulas in Excel. I can see the changes in duration relative to interest rates. But if you were to ask me to 'explain' it to someone, then that's where I have trouble, because I don't fully understand it, nor am I sure if what I'm reading is even correct.
What if you think of duration as the length of time it takes to repay the price of a bond with its cash flows? Consider a $1,000 par zero coupon bond that matures in 4yrs. It takes 4 years to recoup $1,000. What about a $1,000 par bond that matures in 4yrs and that pays a 5% coupon each year? How long does it take to recoup $1,000? Forget interest rates and PV for a minute and just think about what the effect of having coupons is.
The zero - coupon is understandable because you are essentially receiving what you've invested at the end of maturity, which is the same as duration. I'm guessing w/ a coupon paying bond, you are recovering your initial investment quicker due to receiving cash flows. Now are we talking about recovering the PAR, or price paid for the bond? Referring back to your example, duration will be less than 4 years, since I'll actually be receiving cash flows already in the process while I'm earning back my $1,000? Hmmm...
Exactly. Then what about a coupon bond that pays 2% or 20% coupons? Now, you should be starting to get the idea.
I think I understand this, yet I'm not sure if I'm over thinking it. LOL Given the two, if all else is equal, the 20% will have a lower duration. 20% Coupon = Lower duration. As you'll receive your invested cash quicker. However, from the general idea of duration, higher coupons = less price volatility in relations to interest rates. That 2% WILL see more sensitivity. I suspect, in an ANTICIPATION of rising interest rates, we want short duration/maturities so that we can re-invest at higher rates. hmmm. Thanks..