Bond investors face two main risks:
- Credit risk is the chance that a bond will default and won't be able to repay principal and interest as promised.
- Interest rate risk is the possibility that a bond's price will fall if market interest rates rise.
A change in price is important if the investor needs to sell the bond prior to maturity, in which case he or she may receive less than the face value of the bond or what was paid for it.
This is where duration comes in. Duration measures how a bond's price can be expected to react to changes in market interest rates. It's an important concept for bond investors to understand and one they should consider when selecting a fixed-income investment.
While the direction of interest rates is impossible to predict, duration can tell you how the value of a bond portfolio—individual bonds, bond mutual funds or exchange-traded funds—may change if interest rates do.
Differences Between Maturity And Duration
Although they sound similar and both are measured in terms of years, a bond's maturity and its duration aren't the same thing. However, the bond's maturity date is one of the two main factors that go into calculating its duration, along with the coupon rate.
Bonds with shorter maturities and higher coupons have shorter durations, while bonds with long maturities and low coupon rates have longer durations. In general, bonds with long durations are more sensitive to changes in interest rates and are therefore more risky on a price basis, while shorter duration bonds are less risky.
For example, a bond with a 3% annual coupon and a 20-year maturity is more risky on a price basis than a five-year bond with a 5% coupon.
This is because higher coupon bonds with shorter maturities pay out more of their cash flow to the investor faster than long-term bonds with lower coupons. As a result, the latter's coupon and principal payments are at greater risk because the investor has to wait longer get his or her money back.
Although the math involved in calculating a bond's duration is fairly complicated, duration essentially measures what percentage of a bond's price would go down for each 1% rise in current interest rates for each year of duration.
For example, if rates were to rise 1%, a bond or fund with a five-year average duration would lose 5% of its value. Likewise, if rates were to rise 2%, the bond or fund would lose 10%.
Duration Works In Multiple Ways
Duration works both ways. If interest rates were to decline, the value of a bond with longer duration would go up more than a bond with shorter duration. So, if interest rates were to fall by 1%, a bond with a duration of five years would rise in value by 5%. If rates were to fall 2%, the bond's value would rise 10%.
You can usually find the duration of a bond or bond fund on your broker's website. Once you know the duration, you will know how it can be expected to react if interest rates change. You can then decide if that investment is appropriate for you given your appetite for risk and your belief in the future direction of interest rates.
Otherwise similar bonds or funds have different durations depending on their maturities and coupons. For example, two different bonds issued by ABC Company carry 3% coupons, but one matures in five years and the other in 10 years. The five-year bond would have a shorter duration and thus less price risk because it would repay its principal and interest to the investor faster than the longer bond.
The same idea works with bonds with similar maturities but different coupons. Let's say that XYZ Company has two bonds that mature in five years. One has a 3% coupon and the other a 5% coupon. The 3% bond would have a longer duration and thus more price risk than the 5% bond because the holder of the 5% bond will get more money back faster than the holder of the 3% bond.
Duration is an important component for investors to understand when deciding what kind of bond or bond fund to buy. Duration is a function of a bond's maturity date and its coupon rate and measures how sensitive a bond's price is to a change in interest rates.
Bonds with long durations are riskier than those with shorter durations on a price basis. Generally speaking, bonds with long maturities and low coupon rates have longer durations than bonds with shorter maturities and higher coupons.