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Duration Definition and Its Use in Fixed Income Investing

What Is Duration?

Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.

A bond’s duration is easily confused with its term or time to maturity because certain types of duration measurements are also calculated 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 nonlinear and accelerates as the time to maturity lessens.

Key Takeaways

• Duration measures a bond’s or fixed income portfolio’s price sensitivity to interest rate changes.
• Most often, when interest rates rise, the higher a bond’s duration, the more its price will fall.
• Time to maturity and a bond’s coupon rate are two factors that can affect a bond’s duration.
• Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows.
• Modified duration measures the price change in a bond given a 1% change in interest rates.
• A fixed income portfolio’s duration is computed as the weighted average of individual bond durations held in the portfolio.
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What Is the Purpose of Duration?

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change 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). For example, if rates were to rise 1%, a bond or bond fund with a five-year average duration would likely lose approximately 5% of its value.

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

How Is Duration Used?

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 that 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. 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.

The duration of a zero-coupon bond equals its time to maturity since it pays no coupon.

What Are Types of 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 term “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 that 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.

Why is it called duration?

Duration measures a bond price’s sensitivity to changes in interest rates—so why is it called duration? A bond with a longer time to maturity will have a price that is more sensitive to interest rates, and thus a larger duration than a short-term bond.

What are some different types of duration?

A bond’s duration can be interpreted in several ways.

Macaulay 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 Macaulay duration into an estimate of how much the bond’s price will rise or fall with a 1% change in the yield to maturity.

Dollar duration measures the dollar change in a bond’s value to a change in the market interest rate, providing a straightforward dollar-amount computation given a 1% change in rates.

Effective duration is a duration calculation for bonds that have embedded options.

What else does duration tell you?

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. Fixed-income traders will use duration, along with convexity, to manage the riskiness of their portfolio and to make adjustments to it.

Bond traders also use key rate duration to see how the value of their portfolio would change at a specific maturity point along the entirety of the yield curve. When keeping other maturities constant, the key rate duration is used to measure the sensitivity of price to a 1% change in yield for a specific maturity.

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