Duration is an often confused term when it comes to financial fixed income investing. After all, in your everyday life, the definition of duration is the length of time it takes for something to occur. To add to the confusion, there are multiple variations of duration in the investing world, only some of which are measures of time. In fixed income investing, duration most often refers to modified duration, and investors must understand its impact on the fixed income holdings in their portfolios.
Simply put, modified duration is the measure of a bond’s price sensitivity to changes in interest rates. It is not a calculation of time, nor should it be referred to in years or any other length of time.
If a bond has a duration of 3, its price will change ~3% for every 1% (or 100 basis points) change in interest rates. If interest rates were to rise 2% (or 200 basis points), the price of the bond would fall by ~6%. Keep in mind the
inverse relationship between a bond’s price and interest rates. Conversely, if interest rates were to fall 1%, the price of the bond would rise by ~3%. It is measuring the bond’s price sensitivity, not its maturity.
The higher a bond’s duration, the more its price will adjust as a result of changes in interest rates. Duration is nonlinear – it will decrease as a bond approaches its maturity. Both time to maturity and a bond’s coupon rate affect bond duration. All other factors being equal, a bond with one year left to maturity will have a lower duration than a bond with eight years left to maturity. There is less interest rate risk associated with the shorter bond, and therefore its price will be relatively more stable. All other factors being equal, a bond with a higher coupon will pay back an investor’s original investment more quickly and therefore have less interest rate risk and a lower duration.
Why does duration matter? For the last year or so, we have suggested that extending out in maturity and therefore taking on more duration risk is a long-term positive for optimizing return. The motivation is to boost long-term yield (increase income) and capitalize on higher yield opportunities for an extended period while interest rates remain elevated. Although higher durations expose investors to more price sensitivity, a couple of factors are considered. Many investors buy and hold individual bonds until they mature. In that case, price movements are not realized when held to maturity. The risk to price movement only matters if the bond is sold before its maturity. As each bond approaches maturity, its duration will decrease.
