Duration

Measure of a bond's price sensitivity to interest rate changes.

Duration is a metric that measures how sensitive a bond's price is to changes in interest rates. Expressed in years, it helps investors estimate how much a bond's value will rise or fall when interest rates shift. The concept accounts for the timing and size of all future cash flows from the bond, including periodic coupon payments and the final principal repayment. There are two primary types of duration: Macaulay duration and Modified duration. Macaulay duration calculates the weighted average time an investor must hold a bond until its cash flows pay for itself. Modified duration adjusts this figure to show the percentage change in a bond's price for every 1% change in interest rates. Generally, bonds with longer maturities or lower coupon rates have higher duration, making them more sensitive to interest rate fluctuations. Investors use duration to manage interest rate risk within a fixed-income portfolio. If an investor expects interest rates to rise, they may seek bonds with lower duration to minimize potential price declines. Conversely, if rates are expected to fall, choosing bonds with higher duration can maximize potential price gains. A key pitfall is assuming duration is perfectly linear; for large interest rate shifts, a bond's price behavior is also affected by its "convexity," which duration alone does not capture.

A bond has a modified duration of 7 years and is currently trading at $1,000. If market interest rates suddenly rise by 1% (100 basis points), the bond's price is expected to fall by approximately 7%, dropping to $930 ($1,000 - ($1,000 0.07)). If interest rates instead fall by 1%, the bond's price is expected to rise by 7% to $1,070.