Do you own bonds or have money invested in a bond fund? If so, your interest rate isn't the only number you should know. You should also know a bond's duration.
Some bonds are more sensitive to interest rate changes than others, and that sensitivity is known as a bond's duration. That sensitivity is also known as duration risk. That's not to be confused with a bond's maturity, which is simply the date on which a bond issuer must repay the principal of a bond to the bond holder in full.
Related: Think You Know Bonds? Think Again
Given the Fed's decision to begin lifting short-term interest rates, duration merits your attention.
A well-known maxim of bond investing is that when interest rates rise, bond prices tend to fall, and vice versa. But how sensitive a bond is to changes in rates depends on duration. Generally, the longer the duration, the more sensitive your bond investment will be to changes in interest rates.
To get a better handle on your risk, here are five things you should know about bond duration:
1. Why do bonds tend to fall in value when interest rates rise?
To understand bond duration, it's important to first understand how interest rates impact bond prices.
Let's say you bought a $1,000 bond with a 10-year maturity and a 6 percent coupon rate at face value. Now let's jump forward. If one year later, interest rates have gone up and a comparable bond is issued with a 7 percent coupon rate, suddenly the bond you are holding looks less appealing.
If you wanted to sell your bond before it mature, you'd likely have to sell at a price below face value, because investors now expect to be making 7 percent.
Conversely, if interest rates decline, your bond would suddenly look more attractive, and would likely demand a price higher than face value should you to sell it before maturity.
2. What exactly is bond duration?
Bond duration is a measure of the degree to which a bond investment is likely to change in value if interest rates were to rise or fall. The higher the number, the more sensitive your bond investment will be to changes in interest rates.
Generally speaking, for every one percentage-point change in interest rates, a bond will rise or fall in the opposite direction by an amount equal to its duration number.
For example, if a bond has a duration of 10 and interest rates increase by 1 percentage point, then that bond's price would be expected to decline by approximately 10 percent. If interest rates were to decline 1 percentage point, the bond's price would be expected to increase approximately 10 percent.
Keep in mind, while duration assumes that for every movement in interest rates, there is an equal change in bond price in the opposite direction, there are exceptions to the rule.
3. How is bond duration calculated?
There is more than one method of measuring duration.
One type, Macaulay duration, is named for Frederick Macaulay, an economist who developed the concept in 1938. Macaulay duration, expressed in years, calculates the weighted average time before an investor would receive the bond's cash flows.
Modified duration—a version of Macaulay duration—accounts for changes in a bond's yield to maturity. Modified duration directly measures price sensitivity.
Generally speaking, the calculations used to determine duration take into account a number of factors such as how much interest a bond pays during its lifespan, as well as a bond's call features, yield, and maturity, which is the length of time before the bond's principal is repaid.
4. Where do I find a bond or a bond fund's duration?
To find a bond fund's duration, look at the fund's Fact Sheet, which can often be found in the “Bond Holding Statistics” section.
Finding the duration of an individual bond can be trickier. Start by asking your investment professional or the bond's issuer.
5. If my bond or bond fund has a low duration, does that mean that it's low risk?
Not necessarily. In addition to duration risk, bonds and bond funds are subject to credit risk, default risk, inflation risk, call risk, and other risk factors.
It's important to read a bond's offering document or a bond fund's prospectus to learn about all of these risks. For more on the various risks bonds pose, check out What You Need To Know Before Investing In Bonds.
For a more complete discussion of bond risk factors, visit FINRA's Bonds section.