What Is Bond Duration?
Bond duration measures how much a bond's price moves when interest rates change, expressed as a number of years. A duration of seven means the price falls roughly seven percent for every one percentage point rise in rates, which makes it the single most useful risk number a bondholder has.
“Bonds are safe” is the most expensive sentence in personal finance, because it describes a two-year government bill and a thirty-year corporate bond with the same word. Duration is the number that separates them.
How it works
Duration converts a rate move into a price move. A bond with a duration of 7 falls about 7% if rates rise one percentage point, and rises about 7% if they fall one. Duration 2 gives 2%. Duration 17 gives 17%.
That is the entire practical content of it. It is also, underneath, a weighted average of when the bond’s money arrives — which is why it is quoted in years.
Longer bonds have longer duration, because more of the money is further away and therefore more sensitive to the rate used to discount it.
A bigger coupon shortens duration. More of the total is paid earlier, so the average arrival time moves closer and the bond becomes less rate-sensitive. Two bonds maturing on the same day can have materially different durations for this reason alone.
A worked example
Two bonds, same issuer, same day. One matures in two years, one in thirty. Call their durations 2 and 17.
Rates rise by one percentage point. The short bond falls about 2%. The long bond falls about 17%.
Nothing about the issuer changed. No default, no downgrade, no news. One holding lost a rounding error and the other lost a sixth of its value, and the only variable was a property neither holder necessarily knew.
Put that next to equity volatility. On this site’s shared series the median bar range is 0.493 and the largest single bar was 2.338 — roughly 0.5% and 2.3% on a series around 100. A 17% move from one announcement is several times the biggest single bar this series ever produced.
So a long bond is not a low-volatility asset. It is a low-volatility asset only while rates are still.
Where it is used
Matching duration to a horizon is the main use. If money is needed in five years, holding bonds with a duration near five means rate moves damage the price and lift the reinvestment rate in roughly offsetting amounts.
And hedging uses it directly. Offsetting the duration of a holding with an opposite position of the same duration neutralises the first-order rate move, which is the standard way institutions carry bonds without carrying a view on rates.
Where to find it
Every bond fund publishes it, usually as “average effective duration” on the factsheet, sometimes just “duration.” It is a single number and it is the fastest way to know what a fund actually holds.
The rough shortcut for an individual bond: duration is a little less than maturity for a coupon-paying bond, and equal to maturity for a zero-coupon one. A ten-year bond with a healthy coupon typically lands around seven or eight.
Two figures get used and they answer slightly different questions. Macaulay duration is the weighted average time until the money arrives, in years. Modified duration is the price-sensitivity number — the one that gives the percentage move. In practice a platform quoting “duration” almost always means modified, and the two are close enough that the distinction rarely changes a decision.
What matters is checking it before buying rather than after a rate move. The number is published in advance, it is not an estimate of anything uncertain, and it tells you the size of the loss you are signing up for if rates go the wrong way. Almost nobody looks, which is why the word “safe” keeps getting attached to holdings that can fall by a sixth in an afternoon.
The original data
Use this site’s thirty-year fee measurement as the scale: 5 basis points a year costs 1.5% of the final balance, 20 costs 5.8%, 75 costs 20.2%, 150 costs 36.5%.
Now compare a single rate move. A duration-17 bond loses about 17% on a one-point rise — in one event. That is roughly what a 75-basis-point annual fee costs over three decades, arriving in an afternoon.
And shortening duration is not free. Selling long and buying short costs a round trip — 0.0098 here, about 2% of the median bar range — so repositioning after the move has already happened pays a cost to lock in the loss.
When it fails
The characteristic failure is buying a long-duration bond fund for safety. The word “bond” carries an assumption of stability, the factsheet’s duration figure is not read, and a fund with an average duration of 15 is bought as the cautious part of a portfolio. One rate cycle later it is down more than the equity allocation it was meant to balance. Nothing went wrong with any holding — the fund did exactly what its duration said it would, to somebody who had not looked.
A second failure is treating duration as exact. It is a first-order approximation and it understates the true move on large changes — which bond convexity covers, and which happens to work in the holder’s favour.
A third is ignoring it in a rising-rate environment, where the number tells you the damage before it arrives rather than after.
A fourth is assuming duration equals maturity. Only a zero-coupon bond has them equal; every coupon shortens the gap.
And a fifth is applying it to a callable bond, where the issuer can end the schedule early and the usual arithmetic stops describing the instrument.
Related
Interest rate covers the variable duration converts into a price move. Yield curve covers which rate is actually moving. And bond convexity covers the error in duration’s approximation.
Duration is the number that turns ‘bonds are safe’ into something you can actually check. A two-year government bond and a thirty-year one get described with the same word and behave nothing alike, and the whole of that difference is in one figure most people holding bonds have never looked up.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.