What is Duration?

Duration measures how sensitive a bond's price is to changes in interest rates. A bond is a loan to a government or company that pays regular interest, called the coupon, and repays the original sum at the end. When interest rates in the wider market rise, existing bonds paying the old, lower rate become less attractive, so their prices fall. When rates drop, their prices rise. Duration puts a number on this see-saw. It is expressed in years and roughly reflects the average time it takes to receive a bond's payments, weighted by their size. The longer that time, the more the price reacts to a change in rates.

A useful rule of thumb is that a bond's price moves by about its duration in per cent for each one percentage point change in interest rates, in the opposite direction. Say you invest $10,000 in a hypothetical bond fund with a duration of 10 years. If rates rise by 1 percentage point, the price falls by roughly 10 × 1% = 10%, so the holding drops by about $1,000 to $9,000. If rates fall by 1 percentage point instead, it rises by about 10%, to roughly $11,000. A fund with a duration of 2 years reacts far less: the same 1-point rise costs about 2 × 1% = 2%, or $200, leaving $9,800.

Duration is an approximation. It works well for small rate changes but less well for large ones, because the link between price and yield (the return a bond offers at its current price) is curved rather than a straight line. It also assumes that rates for all bond lengths move together, which is not always the case. A common misunderstanding is that government bonds are always safe. They rarely default, but a long-duration bond can still lose a lot of value when rates climb. In 2022, US inflation, the general rise in prices, reached about 9% and long-term Treasuries, which are US government bonds, lost about 30%.

For a private investor building a long-term portfolio, duration explains much of how the bond part of a mix such as a 60/40 portfolio reacts to interest rates. Short-duration bonds and Treasury bills move little when rates change, while long-duration bonds swing more in both directions. Fund providers usually publish a fund's duration, which lets investors see how much interest rate risk they hold and compare it with when the money is needed.

By Dr. Harry Hamann

What does a duration of 5 years mean?
It means the bond's price would move by roughly 5% for each one percentage point change in interest rates, in the opposite direction. A 1-point rise in rates would cut the price by about 5%, while a 1-point fall would lift it by about 5%.

Is duration the same as maturity?
No. Maturity is the date the bond repays its original sum. Duration also accounts for the coupon payments received along the way, so it is usually shorter than maturity. Only a bond paying no coupon has a duration equal to its maturity.

Why do bond prices fall when interest rates rise?
An existing bond pays a fixed coupon. When new bonds offer higher rates, buyers will only take the older, lower-paying bond at a lower price, one that brings its yield in line with the market. The longer the bond's duration, the larger that price adjustment.