Duration

Duration is a measure of risk that is typically applied to bonds. It describes how sensitive a given bond is to movements in interest rates. Think of the relationship between bond prices and interest rates as being like a see-saw: when one side goes up, the other goes down.

Modified duration (which can be found in the fact sheet of most bond funds) tells you the likely percentage change in a bond’s price in response to a one percentage point (100 basis points) change in interest rates. The higher the duration, the higher the “interest-rate risk” of the bond – that is, the larger the change in price for any given change in interest rates. So if a bond has a duration of ten, it indicates that a single percentage point rise in interest rates would cause the bond price to fall by 10% (while a single percentage-point drop in interest rates would cause the bond price to rise by 10%).

Modified duration is derived from Macaulay duration, which calculates the weighted average time (measured in years) that it takes for the bondholder to receive the bond’s cash flows. Put more simply, it shows how far into the future the holder’s pay-off lies. For zero-coupon bonds (those that pay no income at all), the duration is always the remaining time to maturity. For interest-paying bonds, duration is always less than maturity (because in weighted average terms, the cash flows will always be paid out before maturity).

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As a rough guide, the duration of a bond increases along with maturity – so the longer a bond has to go until it repays its face value, the longer its duration. Also, the lower the yield on the bond, the higher its duration – the longer it takes for you to get paid back. Finally, as interest rates rise, duration falls. So does the bond’s sensitivity to further rises, which implies that raising rates in a zero-rate environment is likely to be more disruptive than raising them from a higher starting point.