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duration

A measure of how sensitive a bond's price is to interest rates: price change ≈ −duration × change in yield.

Duration measures how sensitive a bond's price is to a change in interest rates. It is expressed in years, roughly the average time until you get your money back, and it turns into a handy estimate: price change ≈ −duration × change in yield. A bond fund lists its duration on the factsheet, and that one number tells you most of its rate risk.

The rule works in both directions. With a duration of 5, a 1-point rise in yields means a fall of about 5%, and a 1-point drop means a gain of about 5%. Longer bonds and bonds with smaller coupons have higher durations, so they swing more. The estimate is best for small moves; for large ones the real change is a little different.

Duration is the practical way to match bonds to a goal. Money needed in two years belongs in something with a short duration, which barely moves; a long-duration fund can lose a large share of its value in a year when rates jump, even though nobody defaulted.

Example

Zapas compares two $1,000 bonds. The short one has a duration of 2; the long one, 15. If yields rise by 2 points, the short bond falls about 2 × 2 = 4%, to $960, while the long bond falls about 15 × 2 = 30%, to $700.

Over the synthetic Tessaro history the same gap shows up in the swings: short bonds have a standard deviation of 1.0% a year and a worst year of +2.9%, while long bonds have 6.9%, a worst year of −16.0% and 9 losing years. That is why Zapas keeps the money users need soon in the short bond fund.

Common mistakes

  • Confusing duration with maturity: they are related but not the same number.
  • Applying the rule to large rate moves as if it were exact; it is an estimate.
  • Holding a long-duration fund for money needed soon because it has a slightly higher yield.
  • Ignoring the fund's duration on the factsheet and judging a bond fund only by its yield.

Learn it in the course