Whether you take an aggressive or conservative approach to investing, your asset allocation is likely to include some bonds. When reading about or researching bonds, you’ll hear about duration, an important metric that investors use when deciding whether or not to invest in certain bonds. Here’s what duration tells you about a bond and its suitability as an investment.What Is Duration? Definition and Examples
Duration is a measurement of the time that it will take for you to receive half of the remaining cash flows from a bond. It’s measured in years, with a longer duration meaning that it will take longer for you to earn half of the remaining payouts. All things being equal, a bond’s duration will decrease as it matures.
In practical terms, investors care about duration because it also indicates how sensitive a bond’s price is to changes in interest rates. It helps investors to predict how much they will make (or lose) as bond prices change with inflation. A bond’s price and duration have an inverse relationship. If one goes up, the other goes down.
As a simple example, let’s say you have a bond with a duration of five years. If interest rates increase by 1%, the bond’s price will decrease by 5%. If interest rates somehow increase by 2%, the same bond’s price would decrease by 10%. And if you have a bond with a duration of five years and the interest rate decreases by 1%, then the bond’s price will increase by 5%.
The exact calculations behind duration are a bit complex, but you don’t need to know them to understand why duration is useful. Still, it’s important to understand that there are technically two types of duration. Macaulay duration measures how long it will take for you to receive half of a bond’s remaining payouts, while modified duration measures a bond’s price sensitivity. People commonly confuse the two types. As a general rule, modified duration (measuring price sensitivity) is usually what people are referring to when they talk about bond duration.How Duration Interacts with Bond Prices
Duration is valuable when you are looking to buy or sell bonds or bond mutual funds on the market. To understand why, it’s important to talk about what a bond’s par value and price are.
Par value is the face value of a bond. If you buy a $1,000 bond, the par value is $1,000 and you will receive $1,000 when the bond reaches maturity. Par value does not change during the term of a bond, no matter market interest rates or bond prices.
When people refer to the price of a bond, they are referring to its market value. Much like stocks and other securities, the market value of a bond will vary over time and even over the course of a single day. Factors that influence bond prices include market conditions as well as general supply and demand.
Because bond prices change, it’s possible for a bond to be worth more or less than its face value. It’s also possible to buy a bond for more or less than its par value. (However, you will still receive the par value of the bond once it reaches maturity.) These changes in price drive investors to consider duration. Duration tells them how a bond’s price could fluctuate, either up or down, in the future. Knowing how price could change over time allows you to attempt making money from the purchase and sale of bonds.How Bond Maturity Impacts Duration
Like other fixed-income securities, such as certificates of deposit (CDs), the maturity date of a bond is the date when your bond will reach the end of its term, also known as reaching maturity. For a 10-year bond, the maturity date is 10 years after the date of issue. When a bond reaches maturity, you will receive the par value of the bond. A bond’s maturity is set when it’s issued and will not change during the bond’s term.
Similarly, the term to maturity is how long you have between now and your maturity date. The term to maturity will get shorter as your bond’s maturity date draws closer. Duration and term to maturity move in the same direction. As the term to maturity decreases, so does duration. That’s because as maturity approaches, there is less time between now and when you will receive the entirety of future payments from the bond. Thus your risk of losing value in the future is lower.How Coupon Rate Impacts Duration
Coupon rate is the interest yield of a bond. This is an annual rate. So if you have a $1,000 bond with a 5% coupon, you will earn $50 of interest from the bond each year (5% of $1,000). A bond will pay this amount in addition to its par value.
It’s worth mentioning coupon rate just to say that it shouldn’t be confused with the interest rates that determines bond prices. The rates that impact prices are the market interest rates. A bond’s coupon rate is set in its initial terms.How Duration Impacts Your Portfolio
When deciding what asset allocation to use for your portfolio, it’s important to consider how much risk you take on from your investments. Everyone’s risk tolerance is different and even though bonds often pose lower risk than other securities, there is still risk when investing with bonds. Duration of a bond helps you determine that risk.The Takeaway
The duration of a bond tells you how sensitive that bond’s price is to changes in interest rates. Duration is represented in years and a higher duration means the bond has a higher sensitivity to interest rate changes. Duration is important because it helps you assess the risk that your adding to your investment portfolio if you buy a certain bond. More generally, it also helps you determine whether or not a bond or bond fund is a good fit in your investing plan.Tips to Help You Invest for Retirement
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