Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. Interest rate changes can affect the value of a bank or financial institution’s fixed income (bond) holdings. How a bond or bond portfolio’s value is likely to be impacted by rising or falling interest rates is best measured by duration. ~ PIMCO
Duration is a measurement of a bond’s interest rate risk that considers a bond’s maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond’s value may be to interest rate changes.
Interest rates may change after you invest in a bond and interest rate changes have a significant impact on bond values. Say you invest in a bond at 5% interest. If interest rates increase by 1%, additional investors in the same bond will now demand a 6% rate of return. Because the bond interest payments are fixed each year, the market price of the bond will decrease to increase the rate of return from 5% to 6%.
The key point to understanding how interest rates and bond prices are related. It’s important to remember that interest rates and bond prices move in opposite directions. When interest rates rise, prices of traditional bonds fall, and vice versa. So if you own a bond that is paying a 3% interest rate (in other words, yielding 3%) and rates rise, that 3% yield doesn’t look as attractive. It’s lost some appeal (and value) in the marketplace.
Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise.
Duration risk, also known as interest rate risk, is the possibility that changes in borrowing rates (i.e. interest rates) or the Federal Reserve fund rate may reduce or increase the market value of a fixed-income investment.
Generally, the higher a bond’s duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.
If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a longer duration would be appealing because the bond’s value would increase more than comparable bonds with shorter durations.
As you might conclude, the shorter a bond’s duration, the less volatile it is likely to be. For example, a bond with a one-year duration would only lose 1% in value if rates were to rise by 1%. In contrast, a bond with a duration of 10 years would lose 10% if rates were to rise by that same 1%. Conversely, if rates fell by 1%, bonds with a longer duration would gain more while those with a shorter duration would gain less.
% Change in bond prices if rates spike 1%
Hypothetical illustration of the effects of duration, exclusively on bond prices
In summary, bond duration measures the interest rate risk. It is a measure of the change in bond prices due to a change in interest rate. Duration is measured in years. The higher the duration of the bond, the more will be the price drop as interest rates increase. This is because one needs to wait longer to get their coupon payments and principal amount back.
Bond duration is important as it helps in measuring the sensitivity of a bond’s price to interest rates. If the interest rates were to fall by 1% and bond duration is three years, then the price will increase by 3%. This knowledge will help you understand the effect on interest rate changes on the portfolio returns.
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