Bond Duration
A measure of a bond's sensitivity to changes in interest rates, expressed in years. A higher duration means the bond's price will change more for a given shift in interest rates.
Bond duration quantifies the interest rate risk embedded in a bond or bond portfolio. In simplified terms, if a bond has a duration of 5 years, its price will fall approximately 5% for every 1% rise in interest rates, and vice versa.
Types of Duration
- Macaulay duration — The weighted-average time until a bond's cash flows are received. Expressed in years.
- Modified duration — Adjusts Macaulay duration for the bond's yield to maturity, giving a direct estimate of price sensitivity.
- Effective duration — Accounts for embedded options (callable or putable bonds) and is the most practical measure for complex securities.
Duration is a critical tool for managing fixed-income risk. In a rising interest rate environment, investors may shorten portfolio duration to limit losses. In a falling rate environment, longer duration amplifies gains. Understanding the relationship between duration and the yield curve is essential for any bond investor.