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What are Average Effective Maturity and Modified Duration? How do these impact your investments?

Average Effective Maturity (AEM) is the term that describes the average contract length of bonds in a portfolio, so that investors can analyze whether or not that portfolio matches their investment criteria. For example, if an investor is looking to build a retirement fund, he or she should choose bond portfolios with average maturities matching his or herlikely retirement date. AEM is also used by investors to analyze any likely interest rate risk or sensitivity of a debt portfolio. This also helps fund managers to undertake asset allocation or hedging measures to counteract interest rate sensitivity.

How is AEM calculated?

The average effective maturity is the length to maturity of fixed income investments, calculated by taking the average length by weighting in a portfolio. Weighting is simply the proportion that a particular investment takes up in a portfolio according to its value. Indicated below is an example of various maturity dates but with different weightings, in a fictional portfolio, to show how we calculate average effective maturity. The start date for this portfolio and the bonds is 1 January 2016.

Bond portfolio A – composition Maturity Date Weighting in the portfolio
3-month Treasury 31 March 2016 5%
6-month Treasury 31 June 2016 15%
1-year Treasury 31 December 2016 35%
10-Year Treasury 31 December 2026 25%
20-Year Treasury 31 December 2046 20%
Average Effective Maturity 6.9 years 100%

What does AEM signify?

- AEM and interest rate risk: AEM is used to measure the maturity of a bond portfolio so that investors can gauge the interest rate risk. The higher the AEM, the more sensitive the portfolio is to interest rate risk. This is because interest rates are more likely to change during a longer horizon.

- Modified Duration: This is the measure of sensitivity of a bond’s price to interest rate changes. It is expressed as a percentage change in price per unit for every 1 per cent change in interest rates. So that if modified duration is 5, the bond price would fall by 5 per cent if the interest rate increased by 1 per cent.

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Key Takeaways

  1. Average Effective Maturity (AEM) is the term that describes the average contract length of bonds in a portfolio.
  2. The higher the AEM, the more sensitive the portfolio is to interest rate risk.
  3. Modified duration is the measure of sensitivity of a bond’s price to interest rate changes.

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