You appreciate an umbrella on a rainy day more, notwithstanding you bought it to save yourself from the sun.
Life is like that so are the seasons. Let us not “lo and behold” the season we are in and move on to learn something in between. Actually, in the first month of my new job in the new role of DCM guy, I have been told to find out the Average Maturity of a couple of bonds, which desk was weighing out for prospective trades.
The ‘Umbrella’ in the case in point is a simple excel which calculates average maturity.
I had learned this calculation in the context of loan, as a Project Finance guy, to find out whether the loan structure is eligible for Reserve Bank of India (RBI) approved External Commercial Borrowing (ECB). Typically for an ECB facility, the Average Maturity of the loan should be less than 5 years. However, I used the same excel for structuring few bond proposals to enhance the returns using Duration play. So before we move on to the most important chapter of a book calledBond, we should get acquainted with the basic fundamentals of the game.
Interest Rate – Bond PriceYield trinity decoded
So we all agree that the interest rates and price of bonds are interlinked. When interest rates move down, the prices of the bond move up. Hmm… Okay… But is it well understood why this is so? Let me try. My answer is simple:
 A bond is a fixed coupon instrument. The coupon factors the existing interest rate, so at the time of issuance, the coupon is at par with the interest rate. However when the interest rate changes (let us assumes falls), the security holder starts enjoying an interest rate arbitrage at the expense of the Issuer. As we know that arbitrage cannot exist forever, so other guys jump in to buy that security as it will continue to service the prefixed coupon. This tilts the demandsupply scenario in the favour of the seller and hence the price of bond rises.
 As a corollary, hence yields also fall as by definition it is inversely proportional to the price.
Yield=Coupon/Price
The image above summarizes the motions. On the other hand, when the interest rates move up, the prices of bonds move down. Why?? Now you can guess.
 As the interest rates go up the coupon is lesser than the prevailing market interest rate, so the returns on the bond perish, which leads to investors selling the bonds, which ultimately leads to an oversupply of bonds and hence the price of the bond goes down.
Duration Play and How Bond traders play on Duration?
Duration is defined as the measure of the sensitivity of the Bond price to a change in the interest rate. Besides the Interest rate, Duration also gets impacted by the Coupon rate and hence yields. Bonds with a high coupon rate have a lower duration and viceversa. Why is it so? It is very commonsensical. Look at it from a bond investor’s point of view.
 If, I am receiving the higher timebound coupon, so why on earth I would be bothered about what is happening to the interest rate (knowing I have got enough). Henceforth the price of the bond would be slightly immune to the deltas in interest rate.
 Since yield follows coupon, so yield would also be inversely proportional to Duration.
Now the belowmentioned diagram which depicts the motions of these variables would make complete sense to you.
Let me draw a simile here. People, who invest in the stock market, know the term called Beta. Beta is the measure of price volatility of a stock with a change in the market as a whole. Duration is its bond counterpart in many ways.
When Keynes famously said:” In the long term we all are dead”. He also meant one more thing. Longer the tenor, the closer you are to death so higher the risk of death. And as death is the mother of all risks. The risk perception and hence volatility of bond price goes up, ceterus paribus, when we increase the tenor of a bond. If the coupon rate and the bond’s initial price are constant, the bond with a longer term to maturity will display higher price volatility and a bond with a shorter term to maturity will display lower price volatility.
Show me the Moolah
So when the desk has a firm view about movements of interest rate, then it takes a conscious call to play on the bond’s duration. It translates into buying high duration papers and holding it for some time until the anticipated rate change occurs. To summarize the discussion so far, the secret sauce here is:
 An investor who predicts that interest rates will decline would best potentially capitalize on a bond with low coupon payments and a long term to maturity (longer average maturity), since these factors would magnify a bond’s price increase.
Let us move on to how to execute this moneyspinner concept. Average maturity is the lever through which a trader can play on Duration.
Average Maturity of a Loan
Let’s go back in time and open the umbrella first. The excel below helps a commercial banker to find out the average maturity of the loan in RBI approved format.
 A loan of 400 has been taken and it has a 10 years repayment schedule.
Date of Disbursement (drawal)/Repayment  Drawdown amount  Repayment amount  Outstanding Balance  No of days balance with Borrower  Product 

01042015 
100 
100 
90 
0.06 

01072015 
100 
200 
90 
0.13 

01102015 
100 
300 
90 
0.19 

01012016 
100 
400 
360 
1.00 

31122016 
40 
360 
360 
0.90 

31122017 
40 
320 
360 
0.80 

31122018 
40 
280 
360 
0.70 

31122019 
40 
240 
360 
0.60 

31122020 
40 
200 
360 
0.50 

31122021 
40 
160 
360 
0.40 

31122022 
40 
120 
360 
0.30 

31122023 
40 
80 
360 
0.20 

31122024 
40 
40 
360 
0.10 

31122025 
40 

Average Maturity 
5.88 
Tip: Use the DAYS360 function to find out the No of days balance with the Borrower. Product Column is a product of ‘No of days balance with Borrower’ and Outstanding.
Average Maturity of a Bond
 It tells the investors how sensitive a bond is to change in interest rates. The average maturity of a Zero Coupon Bond is the tenor.
 For coupon paying bonds, the average maturity is similar to the calculation of average maturity of loan minusDAY360 function. The no of days balance with the borrower is simply calculated as the difference between two dates of drawal/repayment.
Structuring of the bond to suit the Duration Play
It can be done using the excel below. The excel is the redemption schedule, which has reduced the Average Maturity of the 400 Face Value, 10year tenor bond to 9 years.
Date of Disbursement (drawal)/Repayment  Drawdown amount  Repayment amount  Outstanding Balance  No of days balance with Borrower  Product 

01012015 
400 
400 
364 
1.00 

31122015 
400 
366 
1.00 

31122016 
400 
365 
1.00 

31122017 
400 
365 
1.00 

31122018 
400 
365 
1.00 

31122019 
400 
366 
1.00 

31122020 
100 
300 
365 
0.75 

31122021 
300 
365 
0.75 

31122022 
100 
200 
365 
0.50 

31122023 
200 
366 
0.50 

31122024 
200 
365 
0.50 

31122025 
200 

Average Maturity 
9.0 
 If the portfolio of a debt fund is loaded with longterm bonds i.e. high average maturity bonds, it will be highly sensitive to interest rates movements. So this card needs to be played with a lot of conviction and gumption to load the portfolio with high duration bonds.
Conclusion
So the final answer to the captioned question for a person who strongly feels that interest rate is going to go down is: Invest in a bond with low coupon payments and a long term to maturity. Period.
Cover Image: The National