Duration

Before you rely on it

What to check

Establish which of the two forms a quoted figure is before you use it.

The common error

Where people go wrong with duration

Treating a Macaulay figure in years as a modified figure in percent. Both get called duration in the same conversation, and swapping them silently produces a price estimate that is wrong by a few percent in whichever direction is least convenient.

Worked through

Duration in plain numbers

Compare two ten-year bonds, one with a 2% coupon and one with a 6% coupon, each priced at par; the 2% bond returns most of its money at the end, so its duration is about 9.2 years. The 6% bond sends back more early, in coupons, so its duration is about 7.8. If rates rise one point, the first falls roughly 9% and the second roughly 7.4%. Same maturity, different sensitivity. Duration compresses the timing of all the cash flows into one number, and that number tells you how far a price moves when yields change.

Easily confused

Duration and its neighbours

Duration is an umbrella term for several related measures. Macaulay duration is the weighted average time to receive the cash flows, in years. Modified duration converts it to price sensitivity. Effective duration measures sensitivity directly for bonds with options. Portfolio duration averages holdings. All of them differ from maturity, the date of the last payment, and from the everyday meaning of duration as length of time. When a fund says its duration is five years, it means a rate change of one point moves its price by about five percent.

In real decisions

Where duration turns up

Bond investors use duration to manage interest-rate risk. Choosing shorter duration reduces sensitivity when rates are expected to rise. Pension funds match the duration of assets to the duration of liabilities. Fund fact sheets list it; comparing bond funds by duration works better than by maturity, since it captures coupon effects. Duration also helps translate a rate forecast into a price forecast for a rough estimate of gains or losses.

Know the edges

Where duration stops being reliable

Duration works well for small, parallel moves in yields and worsens for large ones, where convexity is needed; it assumes cash flows do not change when rates move, which is false for callable and prepayable bonds. Credit risk is separate from rate risk, and duration does not capture it. Yield curves twist and steepen, so a portfolio may not respond as one number suggests, and use it as a guide, not a guarantee.

Quick answers

What people ask about duration

Is duration measured in years? Macaulay duration is, as a weighted time to cash flows. Modified duration is a percentage price change per point of yield. Funds often quote it in years for simplicity.

How can I reduce my portfolio's duration? Shift toward shorter maturities, higher coupons or floating-rate bonds. Each lowers sensitivity to rate changes, usually at the cost of a lower yield.