Duration

Duration is the dependence of the price of a debt instrument (for example, a bond) on interest rates moves. Some types of bond duration are calculated in years, so they can be mistaken for maturity.

A bond's duration is independent from interest rates moves, an unchanging number of years until the principal matures. Duration is a variable value that accelerates as the maturity decreases.

How Duration works

Duration is the number of years to recover the price of the bond by the total cash flows on the bond that the investor will need.

As duration rises, the price of the bond falls due to higher interest rates (risk increases). For example, with an average duration of 5 years, a bond or bond fund could lose 5% of its value if interest rates increase by 1%.

Several factors affect duration. They also include:

• Time to maturity. Risk of interest rate changes and duration increases with a longer maturity. Let's consider 2 bonds with different maturities but the same yield of 5% and the same value of $1,000. The bond with the longer maturity will return its true cost later, its duration and risk are higher.
• Coupon rate. It is the main indicator of the bond for calculating duration. Let's imagine 2 completely identical bonds with different coupon rates. The lower the coupon rate of the bond, the higher the interest rate risk, the longer the duration, and the faster the bond will pay back its initial cost.

Types of Duration

Bond duration can be viewed in 2 different ways in practice.

Macaulay duration is the weighted midpoint time until all the money on the bond is paid. It is an assistance in evaluating and comparing a bond without regard to maturity and with regard to the present value of future payments.

Modified duration is a measurement of the expected bond price change when interest rates change by 1%. It is not measured in years.

Bond prices depend on interest rates inversely. Interest rates fall results in bond prices rising. Interest rates rises result in bond prices falling.

Usefulness of Duration

Interest (interest rate fluctuations) and credit (default) are the 2 main risks affecting the investment value of a bond. These 2 risks can potentially affect the yield to maturity of a bond. Using duration, this potential influence on the price of the bond can be quantified.

For example, the credit quality of a company with difficulties decreases. This means that investors planning to own the company's bonds will require a higher yield to maturity or reward. The price of the bond should decrease for higher yields to maturity. These risks also are applicable for interest rates rise and an issuance of competitive bonds with higher yields to maturity.

Duration strategies

In investment and finance, analysts use concepts such as “long” and “short” duration. Under trading and investing, a short position is the ownership of an asset or a share in an asset (e.g., derivatives), which price will increase when the price decreases. And, a long position is the ownership of an underlying asset or part of an asset, which price will increase if the price increases.

With a long duration strategy, investors focus on bonds with a long time to maturity and a high risk of interest rate changes. Such bonds have a high duration value. A long duration strategy is effective in recessions when interest rates decrease.

A short duration strategy is a focus on bonds with a short term to maturity. It is effective when interest rate changes are unpredictable or interest rates are rising. It helps to reduce risk.