Duration, Credit Spreads and Inflation

Fixed payments do not mean a fixed price

A conventional fixed-rate bond promises contractual cash flows. What another investor will pay for those cash flows changes. “Fixed income” describes an instrument category, rather than a promise that the account balance stays flat.

Separate three questions: how much does price respond to yields; how likely is the issuer to pay; and what will the payments buy?

Duration measures sensitivity

Modified duration estimates the percentage price response to a small change in yield, with other factors held constant. As a rough hypothetical approximation, a bond with modified duration of five loses about 5% if its yield rises by one percentage point.

This is a first-order estimate. Larger moves, curvature in the price–yield relationship, embedded options and changes in cash flows can make it inaccurate. Duration is not simply the number of years until maturity.

For a fund, reported duration summarises portfolio exposure at a point in time. It can change as holdings and market conditions change. A short-duration label reduces one type of sensitivity; it does not remove credit or liquidity risk.

Credit spreads price additional uncertainty

A credit spread is the extra yield over a reference rate or comparable benchmark. It is influenced by perceived default risk, expected recovery, liquidity and market conditions. Comparisons need similar currencies, terms and structural features.

A corporate bond can lose value when its credit spread widens even if the reference government yield barely changes. Falling government yields and widening credit spreads can offset each other. Looking at the policy rate alone misses the mechanism.

A higher yield is compensation being offered, not evidence of a bargain. Ask what risk changed and how the investor ranks if the issuer fails.

Inflation changes what the cash buys

A nominal coupon can arrive exactly as promised and still buy less. Hypothetically, a 4% nominal return with 3% inflation gives a real return of (1.04 ÷ 1.03) − 1, approximately 0.97%, before tax and fees.

Inflation-linked instruments address inflation through specified adjustments, but their market prices still respond to real yields and other risks. They are not immune to losses before maturity.

Match the risk to the obligation

A long horizon does not automatically make a long-duration holding sensible for every job. If the money must be sold to meet a near-term bill, a temporary price decline has an immediate consequence. If payments are being matched to obligations, the payment dates and issuer quality matter as well as quoted yield.

Risk temperament matters when a supposedly defensive holding falls. Know the intended role before the first uncomfortable statement arrives.

What to do with this

For one bond or bond fund, write down duration, credit exposure, currency and whether payments adjust for inflation. Explain which risk could stop it doing its intended job.