Average Effective Maturity

What Is Average Effective Maturity?

For a single bond, the average effective maturity (AEM) is a measure of maturity that considers the possibility that a bond may be called back by the issuer.

For a portfolio of bonds, average effective maturity is the weighted average of the maturities of the underlying bonds.

Grasping Average Effective Maturity

Bonds that are callable can be recovered right on time by the issuer assuming interest rates drop to a level that is invaluable for the issuer to refinance or refund the bonds. The early redemption of bonds means that the bonds will have their life expectancies cut short.

As such, the bonds won't mature on the stated maturity date listed in the trust indenture. Callable bonds, then, at that point, will have an average effective maturity that is not exactly the stipulated maturity whenever called.

The average effective maturity can be depicted as the period of time it takes for a bond to arrive at maturity, making an into consideration that a move like a call or refunding may make a few bonds be reimbursed before they mature. The more drawn out the average maturity, the more an asset's share price will go up or down in response to changes in interest rates (read our term on duration).

Average Effective Maturity and Bond Portfolios

A bond portfolio comprises of several bonds with various maturities. One bond in the portfolio could have a maturity date of 20 years, while another could have a maturity date of 13 years. The maturity at the hour of issuance will decline as the maturity date draws near.

For instance, expect a bond issued in 2010 has a maturity date of 20 years. In 2018, the maturity date of the bond will decline to 12 years. Throughout the long term, the maturity of the bonds in a portfolio will decline, expecting the bonds are not swapped for fresher issues.

The average effective maturity is processed by weighting each bond's maturity by its market value with respect to the portfolio and the probability of any of the bonds being called. In a pool of mortgages, this would likewise account for the probability of prepayments on the mortgages. For simplicity, we should expect a portfolio is comprised of 5 bonds with maturity terms of 30, 20, 15, 11, and 3 years. These bonds make up 15%, 25%, 20%, 10%, and 30% of the portfolio value, respectively. The average effective maturity of the portfolio can be calculated as:

• Average effective maturity = (30 x 0.15) + (20 x 0.25) + (15 x 0.20) + (11 x 0.10) + (3 x 0.3)
• = 4.5 + 5 + 3 + 1.1 + 0.9
• = 14.5 years

On average, the bonds in the portfolio will mature in 14.5 years.

Special Considerations

The average effective maturity measure is a more accurate method for figuring out the exposure of a single bond or portfolio. Especially on account of a portfolio of bonds or other debt, a simple average could be an extremely deceptive measure.

The weighted average maturity of the portfolio is essential to realize the interest rate risks looked by that portfolio. For example, longer-maturity funds are generally viewed as more interest-rate sensitive than their shorter partners.

Features

• Average effective maturity appraises the true maturity of bonds that might be called back.
• Knowing the probability that a bond might be called is essential to computing average effective maturity.
• Callable bonds permit the issuer to recover them prior to the stated maturity, in this manner having below effective maturities than stated.