Equity investors focus on earnings, growth, and valuations. Fixed income requires different mental models.
Duration, convexity, and yield to maturity determine bond returns. Understanding these concepts helps equity investors build balanced portfolios.
The Duration Principle
Multi-asset 2025 performance commentary notes that equities, commodities, credit, and duration all delivered healthy returns in 2025, with bonds again contributing meaningfully thanks to duration exposure.
While investing terms for beginners typically focus on equity concepts like P/E ratios and dividend yields, mastering fixed income fundamentals is equally critical for balancing risk over full market cycles.
Duration measures bond price sensitivity to interest rate changes:
- Duration of 5 means bond loses roughly 5% for each 1% yield increase
- Duration of 10 means bond loses roughly 10% for each 1% yield increase
- Higher duration equals higher interest rate risk
The relationship works inversely too. When yields fall 1%, duration 5 bond gains roughly 5%.
The Calculation Mechanics
Duration isn’t maturity. A 10-year bond doesn’t have duration of 10. Duration accounts for coupon payments received before maturity.
Zero-coupon bonds have duration equal to maturity because no coupons exist. Coupon bonds have duration less than maturity because coupons get paid along the way.
Example framework:
- 10-year zero-coupon bond: Duration approximately 10
- 10-year bond with 5% coupon: Duration approximately 7.5
- 10-year bond with 10% coupon: Duration approximately 6.5
Higher coupons reduce duration because more cash comes early.
The Yield Movement Impact
When central banks raise rates, bond yields rise and prices fall. Duration quantifies the damage.
2022 provided clear example. Federal Reserve raised rates from 0% to 4%+ in months. Long-duration bonds suffered:
- Short-term bonds (duration 2): Lost approximately 8%
- Intermediate bonds (duration 5): Lost approximately 20%
- Long-term bonds (duration 15): Lost approximately 30%+
The duration multiplier created massive dispersion in fixed income returns based on portfolio duration.
The 2025 Recovery
The 2025 healthy returns across duration reflected yields stabilizing and beginning to decline. When yields fall, duration becomes advantage instead of liability.
The same duration 15 portfolio losing 30% in 2022 gained substantially in 2025 as yields fell. Duration cuts both ways.
Equity investors adding fixed income must choose duration based on interest rate outlook and risk tolerance.
The Convexity Concept
Duration provides first approximation of price change. Convexity provides second-order refinement.
Convexity measures how duration changes as yields move. Bonds with positive convexity gain more when yields fall than they lose when yields rise by equal amounts.
The math gets complex but the concept is simple:
- Positive convexity: Duration increases as yields fall, amplifying gains
- Negative convexity: Duration decreases as yields rise, amplifying losses
Most plain bonds have positive convexity. Mortgage-backed securities often have negative convexity due to prepayment risk.
The Yield to Maturity Calculation
Yield to maturity represents total return if bond is held to maturity assuming all coupons are reinvested at same yield.
YTM accounts for:
- Coupon payments received
- Price paid versus par value
- Time until maturity
- Reinvestment of coupons
A bond trading at discount (below par) has YTM above coupon rate. A bond trading at premium (above par) has YTM below coupon rate.
The Role in Multi-Asset Portfolios
Long-run data since 1900 shows bonds providing lower but more stable returns than equities. This stability justifies fixed income allocation despite lower expected returns.
The stability comes from different return drivers:
- Equities: Driven by earnings growth and valuation changes, volatile
- Bonds: Driven by interest rates and credit spreads, less volatile
- Commodities: Driven by supply-demand imbalances, cyclical
- Duration: Provides ballast during equity crashes
The 2025 performance showing healthy returns across all asset classes demonstrates diversification working as intended.
The Duration Ladder Strategy
Rather than choosing single duration, many investors build bond ladders with staggered maturities.
The ladder structure:
- 20% in 1-year bonds (duration ~1)
- 20% in 3-year bonds (duration ~3)
- 20% in 5-year bonds (duration ~5)
- 20% in 7-year bonds (duration ~7)
- 20% in 10-year bonds (duration ~10)
This creates average duration around 5 while providing annual maturities for reinvestment.
The Reinvestment Flexibility
As bonds mature, investors reinvest at current yields. If yields rose, reinvestment captures higher rates. If yields fell, at least some bonds locked in higher historical rates.
The ladder balances yield, duration risk, and reinvestment opportunity.
Many equity investors building first fixed income allocation start with intermediate-term bond fund providing duration 5-7. This captures bond benefits without excessive interest rate sensitivity.
The Credit Dimension
Duration and YTM assume bonds pay as promised. Credit risk introduces default possibility.
Government bonds have minimal credit risk. Corporate bonds have varying credit risk based on company financial health.
Credit spreads represent additional yield corporate bonds pay versus government bonds:
- AAA corporate bond: Minimal spread, ~0.5% above government
- BBB corporate bond: Moderate spread, ~2% above government
- High-yield bond: Large spread, ~5%+ above government
The spread compensates for default risk.
The Inflation-Adjusted Variant
Treasury Inflation-Protected Securities (TIPS) adjust principal for inflation. This changes duration and YTM calculations.
TIPS provide:
- Real yield (yield above inflation)
- Inflation protection through principal adjustment
- Lower nominal yield than regular Treasuries
The real yield represents guaranteed purchasing power return. Regular bonds provide nominal return that inflation can erode.
During high-inflation periods, TIPS outperform regular bonds. During low-inflation periods, regular bonds typically win.
