Portfolio duration is a measure of the average maturity of all the debt instruments in a portfolio, weighted by the relative value that each instrument contributes to the overall portfolio. It gives lenders an idea of how changes in interest rates will impact the value of the debt portfolio.
Specifically, duration measures the sensitivity of the portfolio’s price to changes in interest rates. It indicates the approximate percentage change in the portfolio’s price for a 1% change in interest rates. The longer the duration of a portfolio, the more sensitive it is to interest rate shifts.
Calculation of Portfolio Duration
The most common way to calculate portfolio duration is by using the formula:
Duration = Σ (PVA * Duration) / Portfolio Market Value
Where:
- PVA = Present value of each asset (loan) in the portfolio
- Duration = Macaulay duration of each individual asset
- Portfolio Market Value = Total market value of the assets in the portfolio
This weighted average method accounts for the relative contribution of each asset to the overall portfolio value. The duration of each asset is multiplied by its proportional value, and the results are summed.
Macaulay duration for a single asset can be calculated with the formula:
Duration = (PV(Interest) + PV(Principal)) / PV(Total)
Where:
- PV(Interest) = Present value of the interest payments
- PV(Principal) = Present value of the principal payment
- PV(Total) = Total present value of all payments
So the duration of the entire portfolio is found by taking the asset-weighted average of the Macaulay durations.
Duration of Different Debt Facilities
Lenders use portfolio duration to manage interest rate risk across various types of credit facilities and debt instruments. The duration differs substantially across facility types based on maturity, amortization schedule, interest terms, and more.
Term Loans
A term loan is an installment loan that is repaid over a set period of time. The duration of a term loan depends on factors like:
- Original maturity: The longer the final maturity, the longer the duration
- Amortization schedule: Faster principal paydowns shorten duration
- Interest terms: Fixed rates lengthen duration vs floating rates
For example, a 5-year amortizing term loan with a floating interest rate will have a duration of around 2-3 years. Meanwhile, a 10-year bullet maturity loan with fixed rates could have a duration of close to 10 years.
Term loans are a major component of most bank debt portfolios, so their duration impact is important.
Revolving Credit Facilities
Revolving facilities provide borrowers with access to debt on a floating basis up the committed amount. Their durations are very short compared to term loans.
Factors impacting revolver duration include:
- Maturity: Shorter maturity means lower duration
- Utilization rate: Higher utilization extends duration
- Interest terms: Floating rates keep duration low
Even factoring in renewals and extended maturities, revolvers rarely have a duration over 1-2 years. They are valued for flexibility over duration.
Bonds / Notes
Corporate bonds and notes tend to have high durations compared to loans. They are usually fixed rate with bullet maturities (no amortization).
Key duration drivers are:
- Original maturity
- Coupon rate
- Yield curve positioning
- Call features
For example, a 10-year semi-annual pay fixed rate bond could easily have a duration exceeding 7 years. Structural features like call options can shorten this.
Bonds are less common than loans in commercial lending but occur in some portfolios. Their long durations stand out.
Mortgage Loans
Mortgage loans have embedded prepayment options, complicating their duration. Most mortgages allow borrowers to prepay principal early without penalty. This can radically shorten duration versus the stated maturity.
Factors impacting mortgage duration:
- Original maturity / amortization
- Loan age: younger loans have longer effective maturities
- Interest rate incentives: refinancing incentives shorten duration
Newly originated 15-year and 30-year fixed rate mortgages typically have durations of around 6 years and 8 years respectively. The duration declines over the loan’s life.
Conclusion
By quantifying sensitivity to rate shifts and volatility, duration guides credit spread pricing, risk appetite signaling, and balance sheet positioning.
Sophisticated lenders actively measure portfolio duration from multiple angles – simple averages, stress tests, effective metrics, and distribution analysis. Guidelines for total portfolio duration and concentrations support prudent interest rate risk governance.