Bond duration

Before you rely on it

What to check

Check whether the figure quoted is the Macaulay timing measure or the modified sensitivity measure.

The common error

Where people go wrong with bond duration

Building a bond ladder on maturity dates alone. The rungs look evenly spaced and the interest-rate exposure underneath them is not.

Worked through

Bond duration in plain numbers

A five-year bond with a 4% annual coupon, priced at par with a 4% yield, has a Macaulay duration of about 4.63 years. That is the weighted average time to receive the cash flows, counting coupons along the way. Divide by 1.04 and modified duration is 4.45. So if yields rise by one percentage point, the bond's price falls roughly 4.45%, and if yields fall by a point it rises about the same; a ten-year version of the same bond has a duration near 8.3, and it would lose about 8% under the same move. Longer maturity and lower coupon both push duration up.

Easily confused

Bond duration and its neighbours

Duration is not maturity, though both measure time. Maturity is when the last payment arrives. Duration is a weighted average that counts every payment, so it is always shorter than maturity for a bond paying coupons; it is also different from modified duration and effective duration. Macaulay duration is the weighted timing in years. Modified duration converts that into price sensitivity. Effective duration handles bonds with options, where cash flows change with rates. When a fund quotes one number, check which kind it is, since the interpretation differs.

In real decisions

Where bond duration turns up

Portfolio managers use duration to control interest-rate risk; a fund with a duration of 6 is expected to fall about 6% if rates rise a point; investors compare bond funds by duration instead of maturity because it captures sensitivity in a single number. Liability-driven investors match asset and liability durations so that rate changes affect both alike. Someone who expects rates to rise might choose shorter duration. Someone who needs steady income might choose to hold to maturity and ignore day-to-day price moves.

Know the edges

Where bond duration stops being reliable

Duration is a first-order estimate. It works for small, parallel shifts in yields and gets less accurate for large ones, which is where convexity comes in; it assumes cash flows do not change, so bonds with call or prepayment features need effective duration; it says nothing about credit risk. And yield curves rarely move in parallel, so a portfolio can behave differently from its single duration figure. Use it as a guide to sensitivity, not as a precise forecast.

Quick answers

What people ask about bond duration

Is a higher duration better? Neither better nor worse. Higher duration means more sensitivity to interest rates, which helps when yields fall and hurts when they rise. Choose the level that fits your view and your need for stability.

Does duration equal how long I must hold the bond? No. Duration is a weighted average of when cash arrives and a sensitivity measure. You can hold a bond longer or shorter than its duration.