Duration is a measure of the approximate sensitivityof a non-callable bond’s price to changes in interestrates. For bonds with embedded options—such ascallable bonds, mortgage-backed securities (MBS),and collateralized mortgage obligations (CMOs)—effective duration is generally the preferred measure.Effective duration incorporates the terms for earlyretirement for a bond. In other cases, such aswith Treasury Inflation-Protected Securities (TIPS),duration reflects the sensitivity to a change in
interest rates rather than nominal interest rates, aswith other bonds.
Specifically, duration is a way to estimate theapproximate percentage change in the price of abond for a 100-basis-point (1 percentage point)change in interest rates. A bond with a durationvalue of 4 would be expected to lose 4% of itsmarket value if interest rates rose by 100 basispoints. So why is duration measured in years? Theanswer: Because duration is technically a weightedaverage of the time to maturity of a bond’s cashflows. As such, it can help an investor assess howsoon an initial investment will be repaid—taking intoconsideration not only when the principal should bereturned but also any interest payments that are duealong the way.A bond is a loan from the bond holder or investor tothe bond issuer (for example, a corporation), so it isonly natural for investors’ concern to center on thetimely payment of interest and principal. The bond’sindenture, which is an agreement between the issuerand investors, sets forth the specific terms of thebond, including:
date and, if so, at what price?
fixed or variable?Two bonds with the same coupon rate and the samestated maturity date can have different cash flowpatterns and hence different durations. For example,one bond may pay interest more frequently than theother. Duration can help an investor quantify howthese cash-flow differences may affect the value ofboth bonds. For any given maturity date, higher cashflows from a higher coupon rate result in a fasterpayback period for the investor, hence a shorterduration. A zero-coupon bond has a duration equalto its remaining time to maturity. The duration ofa coupon bond, on the other hand, is
thanits time to maturity—because the investor receivesperiodic interest payments.In addition to the timing of cash flows, inflationmatters because changes in interest rates arefrequently associated with changing trends foreconomic growth and inflation. Higher-than-expectedinflation during the loan repayment period reducesthe purchasing power of both the principal at maturity
1 For more information on TIPS, see “Investing in Treasury Inflation Protected Securities.”
Duration: An example
A bond is trading at $10,000, the price atwhich it was sold. If this bond has a durationof 5 years, and if interest rates rise one fullpercentage point, then the price of the bondwould be expected to fall by about 5% to$9,500—if everything else remains the same.