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.
Want to apply these concepts to your own portfolio?
Create your free account →