What Is Duration?

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond's duration is easily confused with its term or time to maturity because they are both measured in years. However, a bond's term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand is non-linear and accelerates as time to maturity lessens.

How Duration Works

Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates. In general, the higher the duration, the more a bond's price will drop as interest rates rise (and the greater the interest rate risk). As a general rule, for every 1% change in interest rates (increase or decrease), a bond’s price will change approximately 1% in the opposite direction, for every year of duration. If a bond has a duration of five years and interest rates increase 1%, the bond’s price will drop by approximately 5% (1% X 5 years). Likewise, if interest rates fall by 1%, the same bond’s price will increase by about 5% (1% X 5 years).

Certain factors can affect a bond’s duration, including:

Usefulness of Duration

Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest rate risk (interest rate fluctuations). Duration is used to quantify the potential impact these factors will have on a bond's price because both factors will affect a bond's expected YTM.

For example, if a company begins to struggle and its credit quality declines, investors will require a greater reward or YTM to own the bonds. In order to raise the YTM of an existing bond, its price must fall. The same factors apply if interest rates are rising and competitive bonds are issued with a higher YTM.

Duration Strategies

In the financial press, you may have heard investors and analysts discuss long-duration or short-duration strategies, which can be confusing. In a trading and investing context, the word "long" would be used to describe a position where the investor owns the underlying asset or an interest in the asset that will appreciate in value if the price rises. The term "short" is used to describe a position where an investor has borrowed an asset or has an interest in the asset (e.g. derivatives) that will rise in value when the price falls in value.

However, a long-duration strategy describes an investing approach where a bond investor focuses on bonds with a high duration value. In this situation, an investor is likely buying bonds with a long time before maturity and greater exposure to interest rate risks. A long-duration strategy works well when interest rates are falling, which usually happens during recessions.

A short-duration strategy is one where a fixed-income or bond investor is focused on buying bonds with a small duration. This usually means the investor is focused on bonds with a small amount of time to maturity. A strategy like this would be employed when investors think interest rates will rise or when they are very uncertain about interest rates and want to reduce their risk.

Duration Summary

A bond's duration can be split into two different features. The Macauley duration is the weighted average time to receive all the bond's cash flows and is expressed in years. A bond's modified duration converts the Macauley duration into an estimate of how much the bond's price will rise or fall with a 1% change in the yield to maturity. A bond with a long time to maturity will have larger duration than a short-term bond. As a bond's duration rises, its interest rate risk also rises because the impact of a change in the interest rate environment is larger than it would be for a bond with a smaller duration.