With the Federal Reserve planning to continue gradually increasing short-term interest rates, investors should be familiar with the concept of “duration” for fixed income investments.

Most investors will understand that a bond’s “maturity” measures how long a fixed income investment lasts, i.e. when they will receive their principal back from the bond issuer.

What is duration?
Duration is a more esoteric concept, but arguably more important. Conceptually, duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. More practically, using duration allows you to estimate how much a bond’s price is likely to rise or fall if interest rates change, and it can be thought of as a measure of a bond’s sensitivity to interest rate risk.

Recall that interest rates and bond prices move inversely – when interest rates rise, bond prices fall, and vice versa. As maturity increases, duration also increases, and the bond’s price becomes more sensitive to interest rate changes.

In general, the higher the duration, the more a bond’s price will decline as interest rates rise. Generally speaking, for every 1% change in interest rates, a bond’s price will change approximately 1% in the opposite direction, for every year of duration.

For example, if a bond has a duration of five years and interest rates increase 1%, the bond’s price will drop by approximately 5% (1% x 5 years). Likewise, if interest rates fall by 1%, the same bond’s price will increase by about 5% (1% x 5 years).

What affects duration?
Certain factors can affect a bond’s duration, including:

– Time to maturity. The longer the maturity, the higher the duration, and the greater the interest rate risk. Consider two bonds that each yield 5% and cost $1,000, but have different maturities. A bond that matures faster – say, in 1 year – would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.

– Coupon rate. A bond’s coupon rate is a key factor in the duration calculation. If two bonds are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original cost faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

Why does duration matter?
If an investor owns an individual bond, then duration can express the gain or loss they may realize if they want to sell their bond prior to maturity and interest rates change. For example, a 10-year bond with a 5% coupon and semi-annual interest payments has a duration of approximately 7.7 years. So, if interest rates rise by, say, 1%, the owner of this bond can expect the price to fall by about 7.7%, or down to $923. This doesn’t matter if the investor plans to hold the bond to maturity – they’ll then continue to receive their 5% semi-annual interest payments, plus $1,000 principal when the bond matures. But if they may want or need to sell the bond before it matures, duration will help them understand how sensitive the price of their investment is to changes in interest rates.

The concept of duration applies to bond funds (mutual funds and exchange-traded funds), as well.

In short, bonds that have shorter maturities and higher coupons tend to be less sensitive to interest rate changes, all other things being equal.

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