Duration is an analytical tool professional bond portfolio managers use to control interest-rate risk in their portfolios. It helps them meet their performance goals, which include protecting the dollar value of the portfolio when interest rates are rising. It also includes attaining the highest return on investment during periods of high interest rates through price appreciation and positioning investments.
Duration is a measurement of the sensitivity of a bond's market price to changes in market interest rates. It is not a date even if it is expressed as long duration or short duration. Duration is affected by the coupon rate and maturity of a bond. For example, an 8 percent coupon 5-year note has a duration of four years, and that of an 8 percent coupon 30-year bond is 11.3 years.
Use of Duration
A bond with a five-year duration will rise 5 percent in value for every 1 percent decline in interest rates and fall 5 percent in value for every 1 percent increase in interest rates. When a bond portfolio manager expects market interest rates to decline, she increases the average duration of the portfolio. This is because the longer the duration, the greater the rate of increase in the price of the bonds. If she expects market interest rates to rise, she decreases the average duration of the portfolio to minimize the loss in dollar value.
The yield-to-maturity formula assumes that all coupon payments are reinvested at the same rate of interest as the coupon rate. This rarely happens because market interest rates change daily. The way yield-to-maturity is figured tends to cause price movement at the longer maturities to be exponentially greater than at the shorter maturities. Duration quantifies the level of price risk during market interest rate movements.
Selling Your Bond
If you plan to sell a 30-year bond after holding it for 11 years, which isits approximate duration, you are simply creating an artificial maturity date, which lowers the duration. If you hold a bond to maturity, you will receive the full principal, or $1,000 per bond, plus interest. If you sell the bond prior to maturity, you will receive the market price for that bond, which may or may not be equal to its principal value.
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