What Is Bond Duration?
Bond duration measures a bond's sensitivity to changes in interest rates. It measures how long, on average, it takes for the cash flows from a bond to be paid back. The longer the duration, the more vulnerable the bond is to interest rate movements.
Its entire definition is a bit more technical than that because duration gauges how long it will take an investor to be repaid the price of a bond from the cash flows it generates.
As interest rates rise, bond prices fall; for example, if 10-year U.S. rates climb from 2% to 3%, bond prices decline, becoming less appealing. Of course, the opposite is true: if interest rates decrease, existing bonds with greater yields become more attractive.
How Does Bond Duration Work?
When an investor buys a bond, they essentially lend money to the issuer for a set period. In return, the issuer agrees to make regular interest payments, known as coupons, and repay the bond's principal, or face value, when it matures.
However, cash flows from a bond are not always evenly spaced out. For example, a bond may make coupon payments semi-annually but not return the principal until it matures ten years later.
This is where duration comes in. It measures how long, on average, it will take for the cash flows from a bond to be paid back.
To calculate duration, we first need to know the present value of all the cash flows from a bond. The present value is simply the value today of a future stream of payments. For example, if you are promised $100 one year from today, the current value would be less than $100 because you could invest that $100 and earn interest.
The present value of the cash flows from a bond can be calculated using a discount rate, simply the interest rate you would earn if you invested the money today.
Bond Maturity vs Bond Duration
It is important to note that bond maturity and duration are different. Bond maturity is the length of time until the bond expires and the issuer repays the principal. Bond duration, on the other hand, is a measure of a bond's sensitivity to changes in interest rates.
A bond with a longer maturity will typically have a longer duration. However, this is only sometimes the case. A bond with ten years remaining until maturity but with semi-annual interest payments will have a shorter duration than a bond with the same maturity but annual interest payments.
This is because the bond with semi-annual interest payments will have more frequent cash flows than the bond with annual interest payments. As a result, the bond with semi-annual interest payments will be less sensitive to changes in interest rates.
Why Bond Duration Matters
Bond duration is necessary because it measures a bond's sensitivity to changes in interest rates. If interest rates rise, the price of a bond with a longer period will fall more than that of a bond with a shorter duration.
Conversely, if interest rates fall, a bond with a longer duration will rise more than a bond with a shorter duration. This relationship is known as the "duration-interest rate" relationship.
It can also help investors assess the risk of their bond portfolio. For example, if an investor holds a bond with a long duration and interest rates rise, the value of their bond will fall more than the value of a bond with a shorter duration.
As a result, investors need to be aware of their bonds' duration and ensure that it is in line with their risk tolerance.
The Formula of Bond Duration
The formula for the bond duration is as follows:
The Bottom Line
Bond duration measures a bond's sensitivity to changes in interest rates. It is calculated using the present value of the bond's cash flows and discount rate.
It differs from bond maturity in that bond maturity is the length of time until the bond expires and the issuer repays the principal.
Bond duration is essential because it can help investors assess the risk of their bond portfolio. For example, if an investor holds a bond with a long duration and interest rates rise, the value of their bond will fall more than the value of a bond with a shorter duration.
FAQs
1. What is Bond Duration?
Bond duration measures how long, on average, it will take for the cash flows from a bond to be paid back.
2. How does Bond Duration work?
The longer the duration, the more sensitive the bond is to changes in interest rates. If interest rates rise, the price of a bond with a longer duration will fall more than that of a bond with a shorter duration.
3. What is the difference between Bond Maturity and Bond Duration?
Bond maturity is the length of time until the bond expires and the issuer repays the principal. On the other hand, bond duration measures how long, on average, it will take for the cash flows from a bond to be paid back.
4. Why does Bond Duration matter?
Bond duration is essential because it can help investors assess the risk of their bond portfolio. For example, if an investor holds a bond with a long duration and interest rates rise, the value of their bond will fall more than the value of a bond with a shorter duration.
5. What is the formula for Bond Duration?
The formula for the bond duration is as follows: D = N×ΣCFt/(1+r)t.
