Summary:
Computed based on a single bond's duration compared to the duration of bonds in a similar class. The lower the duration of a bond relative to other bonds in an equivalency class, the more stars it will receive. Bonds are rated from five stars (best) to one. These ratings are calculated daily to ensure they reflect the most current market conditions. The following graphic describes the different credit ratings. These descriptions are relative and do not imply recommendations for specific bonds for individual investors.
| Volatility Rating | Explanation |
|---|---|
| 5 Stars | Excellent - Duration of 80% to 100% of similar class of bonds. |
| 4 Stars | Good - Duration of 60% - 80% of similar class of bonds. |
| 3 Stars | Medium - Duration of 40% to 60% of similar class of bonds. |
| 2 Star | Poor - Duration of 20% to 40% of similar class of bonds. |
| 1 Star | Very Poor - Duration of 0% to 20% of similar class of bonds. |
Legend
Black - Bond has a yield in the top tiers of its Equivalency Class. Other factors being equal, you should consider this bond for potential investment.Red - Bond has a yield in the lowest tiers of its Equivalency Class. Other factors being equal, you should consider choosing other bonds with higher yield (ie, higher star rating).
More Information:
Volatility Risk is the exposure of a bond to the volatility of fluctuating interest rates. Changes in interest rates affect the values of investors’ bond holdings, as rates rise bond prices fall, and vice-versa. This risk is measured using duration, which is the average time, in years, for an investor to be repaid the price of a bond by the bond's cash flow, including coupon payments and the payment of the principal at maturity (or call date). The longer the duration, the greater is the investor's risk exposure.
Bonds are rated from one to five stars based on how their durations compare to the duration of bonds in the same equivalency class. The lower the duration of a bond relative to other bonds in the same equivalency class, the more stars it will receive. Duration is the time it takes for an investor to be repaid the price for a bond by the bond's total cash flows.
For example, suppose the current price of a bond is $970, maturity is in three years, the annual coupon payment is $50, and the current market interest rate is 7%. The present worth of the coupon payments and payment of the $1,000 principal is $2,686.23. The duration, calculated by dividing the present worth by the current price is: $2,686.23 / $970 = 2.77 years
Bonds that pay coupon interest will always have a duration less than maturity. Zero coupon bonds, with no coupon payments, have a duration equal to maturity. Using duration, it's possible to approximate how much a bond's price is likely to rise or fall when interest rates change. As interest rates increase, a bond's price decreases. Duration measures how quickly a bond will repay its price. The longer it takes, the greater exposure the bond has to changes in the interest rate environment.
Therefore, the longer the duration, the higher is the interest rate risk (as opposed to default risk).
Here are some of factors that affect a bond's duration:
Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less risk. The longer the maturity, the higher the duration, and the greater the interest rate risk.Coupon rate: A bond's payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration, and the lower the interest rate risk.
Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:
Speculating on interest rates: Investors who anticipate a decline in market interest rates, as a result of, for instance, a stimulative rate cut by the Federal Reserve, would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration.
Matching bond selection to your risk: When selecting from bonds of different maturities and yields, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.