definition
Average Life
Average life is a financial term used primarily in the context of debt instruments like bonds. It represents an artificial measure designed to compare investments with various durations and repayment schedules. The average life of a bond is calculated as the weighted average of the periods during which funds are available, taking into account the specific amounts that become available in each period. By providing a single measure that accounts for timing and amount of cash flows, average life helps investors compare bonds with different profiles more easily.
Examples
Example 1: Balloon Payment Bond
Consider a 10-year bond that pays annual interest but repays the principal in a lump sum at the end of the term (balloon payment). The average life would be closer to the latter years of the bond due to the significant principal repayment at maturity.
Example 2: Amortizing Bond
For a fully amortizing bond that pays both interest and principal in equal installments throughout its term, the average life would be much shorter. This reflects the constant reduction of the principal balance over the bond’s life, causing funds to be available more evenly over time.
Example 3: Zero-Coupon Bond
A zero-coupon bond pays no interest but instead is issued at a discount and repays the face value at maturity. The average life of this bond would be equal to its maturity date, as no funds are available before then.
Frequently Asked Questions (FAQs)
What is the significance of average life in bond investments?
The average life provides a single metric for comparing the effective duration of bonds with different repayment schedules. This helps investors assess the risk and return profiles of various bonds on a more standardized basis.
How does average life differ from duration?
Duration measures the sensitivity of a bond’s price to changes in interest rates, while average life is focused on the timing and amount of cash flows. Average life gives a way to compare bonds based on when and how much cash is received.
Can average life be used for any other debt instruments besides bonds?
Yes, average life can also be applied to other forms of debt that have structured repayment schedules, such as mortgages and loans.
Does average life impact the liquidity of a bond?
While average life itself does not affect liquidity directly, bonds with shorter average lives are often perceived as less risky and thus may be more liquid. Investors may prefer bonds that return principal sooner.
Why is average life considered an “artificial” measure?
It’s termed artificial because it simplifies complex cash flow patterns into a single number. While useful for comparisons, it abstracts details that might be relevant in specific contexts.
Related Terms
Bond Maturity
Bond maturity refers to the date on which the principal amount of a bond is to be paid back in full to the bondholder.
Duration
Duration measures the relationship between a bond’s price and the interest rate fluctuations, and it reflects the weighted average time to receive the bond’s cash flows.
Yield to Maturity (YTM)
Yield to Maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures, considering both interest payments and the difference between the purchase price and the par value.
Weighted Average Maturity (WAM)
Weighted Average Maturity (WAM) indicates the average time to maturity of all the bonds in a portfolio, weighted by each bond’s share of the portfolio’s total market value.
Amortization Schedule
Amortization schedule is a table detailing each periodic payment on a loan (often a mortgage), part of which is the interest and part of which is the principal repayment.
Online Resources
- Investopedia - Bond Maturity
- Investopedia - Duration
- Investopedia - Yield to Maturity
- Securities Industry and Financial Markets Association (SIFMA)
- Federal Reserve Education
Suggested Books for Further Studies
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“Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi
- An extensive look at the bond markets and the strategic approaches used by investors.
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“Fixed Income Mathematics” by Frank J. Fabozzi
- A detailed guide to the mathematics underlying fixed income securities and their valuations.
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“The Handbook of Fixed Income Securities” by Frank J. Fabozzi
- A comprehensive handbook covering detailed aspects of fixed income securities.
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“Investing in Bonds For Dummies” by Russell Wild
- A more accessible guide for new investors wanting to understand the bond market.
Accounting Basics: “Average Life” Fundamentals Quiz
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