Economics
Bond Duration
Quick fact
Duration is measured in years but is not the same as maturity; a zero-coupon bond's duration equals its maturity, while a coupon bond's duration is shorter due to early cash flows.
Why this is interesting
Did you know that a 10-year bond might actually be less sensitive to interest rates than a 5-year bond? The secret lies in duration, a measure that reveals the true risk hidden in bond cash flows.
Read the full explanation
Understanding Bond Duration
Imagine you hold a bond that pays you $50 every year for 5 years and then returns your $1,000 principal. The time it takes to get your money back isn't just 5 years—it's less because you receive some payments earlier. Duration calculates that weighted average time, considering both the amount and timing of each cash flow. This number tells you how much the bond's price will change when interest rates move. For instance, a duration of 4 years means that for each 1% change in interest rates, the bond's price will change by about 4% in the opposite direction.
A deeper explanation
Duration works because bond prices and yields move inversely. The precise formula—Macaulay duration—sums the present values of each cash flow weighted by the time until receipt, then divides by the bond's price. Modified duration then adjusts this to directly estimate price sensitivity: approximate percentage price change = -modified duration × change in yield. This linear approximation is crucial for risk management, allowing portfolio managers to hedge interest rate exposure by matching durations. However, duration assumes a linear relationship, which is why convexity is needed for larger yield changes. Understanding duration empowers investors to compare bonds beyond their maturities and to construct portfolios that align with their interest rate outlook.