Most investors in bonds are familar with the bonds’ maturity. The maturity of a bonds is the point in time when you receive back your principal. It is easy to know the maturity of a bond because most bonds are quoted based upon their maturity (i.e. 5 year bond, 10 year bond, 30 year bond, etc.). However, the duration of the bond is really the key measure of the bond because the duration of a bond measures its sensitivity to changes in interest rates.
Bonds will always increase in value as interest rates fall and decrease in value as interest rates rise. In addition, a bond’s price will always approach its face-value as it approaches its maturity date. To better understand these relationships consider the motivation for buying a bond. When an investor purchases a bond he/she receives a return in the form of an interest payment (or coupon payment) at the prevailing rate in the market at the time of the purchase. Because the investor used his/her money to buy the bond, the investor no longer has that money available to purchase anything else, such as a car or another bond. Now, if interest rates go up, the investor will be worse off because if he/she had kept his/her money and used it to buy a bond now, he/she would receive a higher rate of return in the form of a higher interest rate. Also, if the investor wanted to sell his/her bond in the marketplace, he/she would now have to offer it at a discounted price because the other bonds in the market are offering higher interest rates. This dynamic causes bond prices to fall as interest rates rise.
The reverse is also true. If interest rates fell after our investor purchased his/her bond then he/she would now be better off because if he/she had waited and bought the bond after rates fell his/her return would be less. Now if our investor wanted to sell his/her bond he/she could charge a premium for it because it is offering a rate of interest higher than that available in the market.
What does this have to do with duration? Well, the duration of a bond will impact how sensitive a bond’s price is to changes in the interest rate. In other words, duration will allow you to know how much your bond’s price will change in value for a given change in interest rates. In fact, the duration measures by what percent a bond’s value will change for a 1% change in interest rates. In other words, if a bond has a duration of 3, this means that a 1% increase in interest rates will cause the price of the bond to decrease by 3%. Likewise, a 1% decrease in interest rates will cause the price of a bond to increase by 3%.
There is a mathematical formula for calculating the duration of a bond if you have the correct variables, but that is beyond the scope of this article. Just know that the duration of a bond is available and your broker likely has a computer program that can calculate it for you if you want to know what it is (and of course I suggest that you do know what it is).
But we can take away the math and try to understand duration intuitively. Duration is essentially the weighted average amount of time it takes for you to receive back all the cash a bond is scheduled to pay you. A bond typically pays you your principal back at maturity as well as a fixed coupon payment every six months (there are exceptions to this such as zero coupon bonds and TIPS, which are outside the scope of this article) throughout the life of the bond. Therefore, by definition the duration will always be less than the maturity (except for zero coupon bonds, in which case the duration will always equal the maturity).
The time it takes to receive your cash is important because cash allows you to invest in new bonds at the new prevailing interest rates. So, what factors affect duration? Well, from the discussion above, hopefully it is clear that the following impacts duration:
1. The longer the maturity, the higher the duration.
2. The lower the coupon payment (i.e. interest rate) the higher the duration.
Those are the main factors that affect duration because those are the main factors that affect the timing of the return of an investor’s cash from an investment in a bond. In short, the more cash you receive back, and the faster you receive it back, the lower your duration. Furthermore, the lower the duration of a bond the less sensitive it is to changes in interest rates. This is because if your duration is lower that means you are receiving back your cash sooner and have it available to invest at prevailing interest rates. In other words, your cash is not locked up and unavailable to you as interest rates change.
Therefore, if you think interest rates will be rising, you want to have bonds with low durations so that you can get your cash back quickly and invest it at higher rates. Likewise, if you think interest rates will be falling you are happy with long bonds that have long durations because the interest rate you are receiving on your existing bond is higher than the interest rate you could receive by reinvesting any cash you get back from your bond.