Bonds are (unfortunately) one of the least interesting investment categories, mostly because the just don’t warrant any sort of “sexy” risk like equities. However, duration is one of those terms that anyone holding a bond should understand. It isn’t necessarily a measurement of time, but rather a sensitivity measurement to economic changes (as time would naturally do). Here’s everything you ever wanted to know (or didn’t want to know, but I’m telling you anyway) about bond duration.
What is ‘Duration’?
Duration is a measure of the sensitivity of the price — the value of principal — of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate bond prices are likely to fall, while declining interest rates indicate bond prices are likely to rise.
The duration indicator is a complex calculation involving present value, yield, coupon, final maturity and call features. Fortunately for investors, this indicator is a standard data point provided in the presentation of comprehensive bond and bond mutual fund information. The bigger the duration, the greater the interest-rate risk or reward for bond prices.
It is a common misconception among non-professional investors that bonds and bond funds are risk free. They are not. Investors need to be aware of two main risks that can affect a bond’s investment value: credit risk (default) and interest rate risk (rate fluctuations). The duration indicator addresses the latter issue.
What Are the Effects of Duration?
Duration is measured in years. Therefore, if a fixed income security has a high duration, it indicates that investors would need to wait a long period to receive the coupon payments and principal invested. Moreover, the higher the duration, the more the fixed income security’s price would fall if there is a rise in interest rates. The opposite is true.
Normally, if interest rates change by 1%, a fixed income security’s price is likely to experience an inverse change by approximately 1% for each year of duration.
