Fixed Income 101: Duration

Duration is not an obvious term in the world of fixed income but in the recent climate of rapidly rising interest rates it has become an increasingly important one.

In simple terms duration refers to the anticipated price sensitivity of a bond, or a portfolio of bonds, to movements in interest rates, and is measured in years.

In essence, the higher the duration of a bond, the more susceptible it is expected to be to interest rate risk.

And, with interest rate rises over the last 18 months coming thick and fast from the US Federal Reserve, the European Central Bank and the Bank of England, duration has become a key risk indicator.

To fully grasp its importance, it is helpful to first understand how interest rates and bond prices are connected, and the main thing to remember here is that they move in opposite directions.

So, when interest rates rise, the price of a traditional bond falls and, conversely, bond prices jump following a decrease in interest rates.

To bring this back to the real world, this inverse relationship means that the recent hectic cycle of interest rate rises enacted by central banks has caused bond prices to slump.

 

Rapid rate rises

In recent times interest rates have only gone one way, and that is up. But that may begin to change, with many predicting rates will begin to fall over the next year. What is undeniable, however, is that the last 18 months have been one of the most concentrated periods of rate-hiking ever seen.

So exactly how does duration impact the price of bonds? In general, for every 1% rise or fall or in interest rates, the price of a bond price will move roughly 1% in the opposite direction for every year of duration.

So, for example, if a bond has a duration of 10 years and interest rates rise by 1% the bond's price would be expected to fall by approximately a tenth, or 10%. On the flipside, if a bond has a duration of 10 years and interest rates drop by 1%, the bond's price would be expected to increase by 10%.

 

Duration vs maturity

One point to also remember here is that duration is different to maturity: maturity is simply the number of years left until the bond’s principal must be repaid. And, as such, duration is especially key for those intending to sell their bonds before they reach maturity.

If we go back to our 10-year bond example and you buy a par-value bond for $10,000 with a coupon of 5.25%, then you will get $525 every year until the 10 years is up as well as your $10,000 back. But if you sell that bond before the 10 years is over and interest rates rise then the price of your bond would be expected to have fallen.

So, what to do about it? Well, in a world of rising interest rates, like the one we have lived through over the past couple of years, it may make more sense to invest in bonds with a shorter duration, or to put it another way those that have less interest rate risk. And, likewise, if you expect rates to go down then longer duration bonds will become a much bigger draw.