Bond Duration

• What Is Bond Duration?

• A bond’s duration is a measure of the bond’s sensitivity to interest rate changes. Duration may also
be thought of as a measurement of interest rate risk. 

• Many new bond investors confuse the financial term “duration” with the length of time until a bond is
repaid. The repayment date (or the date when the bond’s face value must be redeemed by the
borrower) is called the maturity date.
• Why Is Duration Important?

• Duration is an important measure of a bond portfolio’s sensitivity to interest rate changes over time.
Knowing the duration of a bond helps you compare bond opportunities, assess each bond’s risk,
and select the right mix for your portfolio.
• Investors who want to capitalize on a trend of falling interest rates may purchase bonds with greater
duration. Those who want to buy bonds during periods of interest rate volatility should look for
bonds with low duration and high coupons. This minimizes their risk (low duration) and maximizes
payments (high coupons).
• The Types of Duration

• There are two main ways to calculate bond duration that investors should know:

• Macaulay Duration

• Modified Duration
• Macaulay Duration
• Named after economist Frederick Macaulay who developed the concept in
1938, Macaulay Duration is the most common method of calculating bond
duration. It measures the weighted average time before a bond holder
receives the bond’s cash flows. It is often used by bond portfolio managers to
calculate risk in an immunization strategy (which will be explained later.)
• How to Calculate Macaulay Duration
• The Macaulay Duration formula reflects the fact that Duration = Present value
of a bond’s cash flows, weighted by the length of time to receipt, and divided
by the bond’s current market value.
•
Macaulay Duration

• where:
• t = period in which the coupon is received
• C = periodic (usually semiannual) coupon payment (in $)
• y = the periodic yield to maturity or required yield
• n = number periods
• M = maturity value (in $)
• PV = market price of bond (in $)
Modified Duration
Modified duration is another popular method of calculating bond duration. It measures the price sensitivity
of a bond when there is a change in yield to maturity.
How to Calculate Modified Duration
The formula for modified duration uses the Macaulay Duration formula as its base. I
Modified Macaulay Duration = Macaulay Duration / (1 + y)
• Five Factors that Affect a Bond’s Duration
• Coupon
• The higher a bond's coupon, the more income it produces early on (and the shorter its duration). The lower the coupon, the
longer the duration (and volatility). Zero-coupon bonds – which have only one cash flow – have durations equal to their
maturities.
• Maturity
• The longer a bond's maturity, the greater its duration (and volatility). Duration changes every time a bond makes a coupon
payment. Over time, it shortens as the bond nears maturity.
• Yield to Maturity
• The higher a bond's yield to maturity, the shorter its duration. That’s because the present value of the distant cash flows (which
have the heaviest weighting) become overshadowed by the value of the nearer payments.
• Sinking Fund
• The presence of a sinking fund lowers a bond's duration because the extra cash flows in the early years are greater than those
of a bond without a sinking fund.
• Call Provision
• Bonds with call provisions also have shorter durations because the principal is repaid earlier than a similar non-callable bond.