What Is Duration?

What Is Duration?

Let me explain duration to you directly: it's a measure, in years, of how long it takes for you to get repaid the bond's price through its total cash flows. I also use it as a tool to figure out how a bond's value might change when interest rates move.

You might confuse a bond’s duration with its term or time to maturity since both are in years, but they're different. The term is just a straight-line count of years until principal repayment, and it doesn't budge with interest rates. Duration, though, is nonlinear—it shortens as maturity approaches.

Key Takeaways

Here's what you need to remember: when interest rates go up, bonds with higher duration see their prices drop more sharply. Time to maturity and the coupon rate are the main things that influence duration. For a fixed-income portfolio, you calculate duration as the weighted average of the individual bonds' durations.

How Duration Works in Investing

Duration tells you how sensitive a bond's or debt instrument's price is to interest rate shifts. Generally, the higher the duration, the more the price falls when rates rise—that means higher interest rate risk. For instance, if rates jump 1%, a bond with a five-year average duration could lose about 5% of its value.

Factors like time to maturity and coupon rate play into this. The longer the maturity, the higher the duration and risk—think of two 5% yielding $1,000 bonds; the one maturing in one year repays faster and has lower duration than the 10-year one. On coupon rates: higher coupons mean faster payback, so lower duration and risk.

Types of Duration

In practice, duration can mean a couple of things. Macaulay duration is the weighted average time until all cash flows are paid, factoring in present values to help you compare bonds regardless of maturity. Modified duration, not in years, measures the expected price change for a 1% interest rate shift.

Remember, bond prices move inversely to rates—rising rates mean falling prices, and vice versa.

Macaulay Duration

Macaulay duration calculates the present value of future coupons and maturity value. It's a standard metric in bond tools, easy for you to access. Since it's tied to time to maturity, higher duration means more interest rate risk or reward.

You can calculate it manually with this formula: MacD = ∑(CF_f / (1 + y/k)^f) × (t_f / PV), where f is cash flow number, CF is amount, y is yield to maturity, k is compounding periods per year, t_f is time until cash flow, and PV is present value of all cash flows. The formula breaks into finding present values and then weighting the average time to those flows.

Macaulay Duration Calculation Example

Take a three-year $100 bond with 10% semiannual coupons ($5 every six months) and 6% YTM. First, find present values of cash flows— that's key, but if you know YTM and current price, you're set since price is the PV of cash flows.

Then, divide each PV by total PV, multiply by time in years, and sum up. For this bond, it comes to 2.684 years. Longer duration bonds are more sensitive; a 20-year bond drops more than a five-year one if YTM rises.

Modified Duration

Modified duration shows how much the price changes if YTM shifts by 1%—crucial if you worry about short-term rate changes. For semiannual coupons: ModD = Macaulay Duration / (1 + YTM/2). Using our example, it's 2.61, so a 1% YTM rise drops the price by $2.61.

As YTM changes, the price change rate accelerates—that's convexity. Fast fact: zero-coupon bonds have duration equal to maturity since no coupons.

Strategies for Using Duration

In duration strategies, 'long' means focusing on high-duration bonds with long maturities and more rate risk—it works when rates fall, like in recessions. 'Short' means bonds maturing soon, reducing risk if you expect rates to rise.

Explain Like I'm 5

Duration is how touchy a bond's price is to interest rate changes. When you buy a bond, you're lending money and getting interest back over time until maturity, but if you sell early, the price depends on current rates. Duration tells you the price swing, so you know the risk of losing money on a sale.

How Will I Use This in Real Life?

Duration helps you decide on bonds based on your risk tolerance and holding period. If rates might rise and you could sell early, go for short durations to avoid big drops. For long-term holds, longer durations are fine since price swings don't hit you.

Why Is Bond Price Sensitivity Called Duration?

It's called duration because it measures the weighted average time to receive principal and interest. This time shifts with rates, so longer-maturity bonds have longer durations and more sensitivity. Economists use hazard rates for future performance likelihood.

What Are Some Types of Duration in Bond Analysis?

Macaulay is weighted average time to cash flows in years. Modified turns that into a price change estimate for 1% yield shift. Dollar duration gives the dollar change per 1% rate move. Effective duration handles bonds with options affecting value.

What Else Does Bond Duration Tell You?

Higher duration means higher interest rate risk, so use it with convexity to manage portfolio risk. Traders use key rate duration for sensitivity at specific yield curve points.

The Bottom Line

As a fixed-income investor, watch credit and interest rate risks. Duration quantifies how these affect bond value—if credit quality drops or rates rise, YTM increases, forcing prices down to match.