¶ … Duration in the Investment Decision
Seasoned financial experts will consider numerous factors when considering potential investments. Common considerations for fixed term securities, such as bonds, will include risk and reward, with the reward assessed through the yield to maturity. However, while the element of yield is important, it should not be the only primary area of consideration; duration, or term to maturity, can also be an essential factor in an investment decision (Goldman Sachs, 2014; Gatzert and Kosub, 2014)).
The duration of an investment may be necessary for a number of reasons, these include, but are not limited, to the link between term and reward, market uncertainty, and the need for liquidity.
Duration and reward
Duration links to the risk and reward element of an investment decision. Generally, longer term investments will provide a higher return compared to short-term investments with similar perceived levels of risk. At the current time, there are poor rates of short to medium term bonds. For example German government 2-year bonds sold in 2014 had a yield rate of -0.38% (McClean and Lewin, 2015). This was a bond with a zero rate coupon, and is not an unusual bond in the marketplace (McClean and Lewin, 2015). In 2014, all German sovereign bonds with maturities less than three years had a negative yield (Goldman Sachs, 2014), and today 10 Eurozone countries also have two-year bonds with negative returns, and the overnight rate with the European Central bank was -0.2%, which is subsequently moved further into negative territory (McClean and...
However, the current market conditions may be sooner than usual, but the differential between short- and long-term investment, with longer term investors providing for a higher than bottle short-term interest rate. This may indicate that there are many reasons for longer term durations to be preferred, especially as they are able to offer a greater yield to maturity. However, market uncertainty creates a difficulty determining whether any given yield rate will be advantageous in the context of future market changes.
Market uncertainty
In any marketplace there will be some uncertainty regarding future potential market/sector performance, and the returns that will be achieved. Fixed term investments may provide some advantages in term of minimizing the risk of uncertainty regarding the return of a particular investment. However, tying up capital in one investment, even if it appears to offer a high rate of return measured through the yield to investment, there is also a potentially great opportunity cost, which increases as the duration of a fixed term investment vehicle increases (Pindyck & Rubinfeld, 2009). Therefore, when considering duration, there may be some preferences for placing money in a relatively stable and safe environment in the short-term, while ensuring there is sufficient liquidity to take advantage of emerging opportunities when market conditions improve (Bodie, Kane, & Marcus, 2014). Therefore, if a…
