Duration tells you how many years it takes for an investor to get back the price of a bond through its cash flows. It also shows how much a bond’s price or a fixed-income portfolio reacts to interest rate changes. People often mix up a bond’s duration with its term or time to maturity since some duration figures are also in years. But remember, a bond’s term is just a straightforward count of years until the principal is paid back, and it stays the same regardless of interest rates. Duration, on the other hand, is more complex and gets shorter as the maturity date approaches.
How Duration Works in Investing?
Duration reflects how much a bond’s price reacts to changes in interest rates. Generally, the longer the duration, the more a bond’s price will fall when interest rates go up, which means there’s more interest rate risk involved. For instance, if rates increase by 1%, a bond or bond fund with an average duration of five years could see a value drop of around 5%. Various elements, like the time until maturity and the coupon rate, can influence a bond’s duration.
Types of Duration
In real life, when we talk about the duration of a bond, it can mean two different things:
Conclusion
Bond investors should keep an eye on two key risks that can impact a bond’s worth: credit risk (the chance that the issuer might not make payments) and interest rate risk (changes in interest rates). Duration helps measure how much these risks could affect a bond’s value. For instance, if a company starts facing difficulties and its credit rating drops, investors will want a higher yield to maturity to hold onto those bonds. To increase the YTM of a bond that’s already out there, its price has to decrease. The same goes for when interest rates go up and new bonds come out offering better yields.