When you’re reading about bonds, it’s almost impossible to not come across the word “ bond duration”. What does it mean and how does it affect your portfolio?
Bond prices and their inverse relationship with interest rates are related to duration. Duration is measured in years and is the approximate measure of a bond’s price sensitivity to changes in interest rates. It calculates how long it will take an investor to be repaid the bond’s price by the bond’s cash flows (coupons). The higher the bond duration, the more its price will drop as interest rates rise. (the greater the interest rate risk)
How Bond Duration Works
For every 1% increase or decrease in interest rates, a bond’s price will change 1% in the opposite direction for every year of duration. For example, if a bond has a duration of five years and interest rates increase by 1%, the bond’s price will decline by 5%. Alternatively, if a bond has a duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approx. 5%.
How it Helps Your Portfolio
Duration is a way for you to compare bonds and adjust accordingly in your investment portfolio.
- For example, if you expect rates to rise, it may make sense to focus on shorter duration investments as they have less interest rate risk.
- If you expect rates to fall, it may make sense to focus on longer duration investments so you can take advantage of price appreciation.
Factors That Affect Duration
- Coupon Rate
- The Higher the Coupon Rate, the Lower the Duration
- The Lower the Coupon Rate, the Higher the Duration
- Time to Maturity
- The longer the Time to Maturity, the Higher the Duration
- The shorter the Time to Maturity, the Lower the Duration
