Portfolio Duration Doesn't Tell the Whole Story

The inverse relationship between bond prices and interest rates is a central tenet of bond math. As rates rise, new, higher-coupon bonds become more attractive than previously issued lower-coupon bonds. To entice investors to buy those lower-coupon bonds, prices must fall. Eventually, higher bond yields will be good for investors, but the short-term pain hits investors where it hurts: lower investment returns because of the drop in bond price.

Experienced bond investors may look at a fund's duration (a measure of price sensitivity owing to changes in interest rates) to determine whether a portfolio is "protected" from rising rates. Duration, however, has several shortcomings. It's a good measure of interest-rate risk for noncallable U.S. Treasury bonds, but it becomes less predictive for funds with more credit risk, such as junk bonds, or those with unpredictable cash flows, such as mortgage-backed securities.