Duration Definition and Its Use in Fixed Income Investing

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What Is Duration?

Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total
cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in
interest rates.

A bond’s duration is easily confused with its term or time to maturity because certain types of duration
measurements are also calculated in years.

However, a bond’s term is a linear measure of the years until repayment of principal is due; it does not change
with the interest rate environment. Duration, on the other hand, is nonlinear and accelerates as the time to
maturity lessens.

Key Takeaways

Duration measures a bond’s or fixed income portfolio’s price sensitivity to interest rate changes.

Most often, when interest rates rise, the higher a bond’s duration, the more its price will fall.

Time to maturity and a bond’s coupon rate are two factors that can affect a bond’s duration.

Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total
cash flows.

Modified duration measures the price change in a bond given a 1% change in interest rates.

A fixed income portfolio’s duration is computed as the weighted average of individual bond durations held in the
portfolio.

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Duration

What Is the Purpose of Duration?

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest
rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater
the interest rate risk). For example, if rates were to rise 1%, a bond or bond fund with a five-year average
duration would likely lose approximately 5% of its value.

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 one 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 calculation duration. If we have two bonds that are
identical with the exception of their coupon rates, the bond with the higher coupon rate will pay back its original
costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower
the interest rate risk.

What Are Different Types of Duration?

The duration of a bond in practice can refer to two different things. The Macaulay duration is the weighted
average time until all the bond’s cash flows are paid. By accounting for the present value of future bond
payments, the Macaulay duration helps an investor evaluate and compare bonds independent of their term or
time to maturity.

The second type of duration is called modified duration. Unlike Macaulay duration, modified duration is not
measured in years. Modified duration measures the expected change in a bond’s price to a 1% change in interest
rates.

To understand modified duration, keep in mind that bond prices are said to have an inverse relationship with
interest rates. Therefore, rising interest rates indicate that bond prices are likely to fall, while declining interest
rates indicate that bond prices are likely to rise.

Macaulay Duration

Macaulay duration finds the present value of a bond’s future coupon payments and maturity value. Fortunately
for investors, this measure is a standard data point in most bond searching and analysis software tools. Because
Macaulay duration is a partial function of the time to maturity, the greater the duration, the greater the interest
rate risk or reward for bond prices.

Macaulay duration can be calculated manually as follows:

where:
� = cash �low number
�� = cash �low amount
� = yield to maturity
� = compounding periods per year
�� = time in years until cash �low is received
�� = present value of all cash �lows
The previous formula is divided into two sections. The first part is used to find the present value of all future
bond cash flows. The second part finds the weighted average time until those cash flows are paid. When these
sections are put together, they tell an investor the weighted average amount of time to receive the bond’s cash
flows.

Macaulay Duration Calculation Example

Image by Sabrina Jiang © Investopedia 2020

This part of the calculation is important to understand. However, it is not necessary if you already know the
YTM for the bond and its current price. This is true because, by definition, the current price of a bond is the
present value of all its cash flows.

To complete the calculation, an investor needs to take the present value of each cash flow, divide it by the total
present value of all the bond’s cash flows and then multiply the result by the time to maturity in years. This
calculation is easier to understand in the following table.

Image by Sabrina Jiang © Investopedia 2020

The “Total” row of the table tells an investor that this three-year bond has a Macaulay duration of 2.684 years.
Traders know that, the longer the duration is, the more sensitive the bond will be to changes in interest rates. If
the YTM rises, the value of a bond with 20 years to maturity will fall further than the value of a bond with five
years to maturity. How much the bond’s price will change for each 1% the YTM rises or falls is called modified
duration.

Modified Duration

The modified duration of a bond helps investors understand how much a bond’s price will rise or fall if the YTM
rises or falls by 1%. This is an important number if an investor is worried that interest rates will change in the
short term. The modified duration of a bond with semiannual coupon payments can be found with the following
formula:
Macaulay Duration
���� = ���
�+� �
�

Using the numbers from the previous example, you can use the modified duration formula to find how much the
bond’s value will change for a 1% shift in interest rates, as shown below:
�.���
�=
$2.61 ���
���� �+� �
�

In this case, if the YTM increases from 6% to 7% because interest rates are rising, the bond’s value should fall by
$2.61. Similarly, the bond’s price should rise by $2.61 if the YTM falls from 6% to 5%. Unfortunately, as the YTM
changes, the rate of change in the price will also increase or decrease. The acceleration of a bond’s price change
as interest rates rise and fall is called convexity.

How Is Duration Used?

Investors need to be aware of two main risks that can affect a bond’s investment value: credit risk (default) and
interest rate risk (interest rate fluctuations). Duration is used to quantify the potential impact that these factors
will have on a bond’s price because both factors will affect a bond’s expected YTM.

For example, if a company begins to struggle and its credit quality declines, investors will require a greater
reward or YTM to own the bonds. To raise the YTM of an existing bond, its price must fall. The same factors
apply if interest rates are rising and competitive bonds are issued with a higher YTM.
The duration of a zero-coupon bond equals its time to maturity since it pays no coupon.

What Are Types of Duration Strategies?

In the financial press, you may have heard investors and analysts discuss long-duration or short-duration
strategies, which can be confusing. In a trading and investing context, the term “long” would be used to describe
a position where the investor owns the underlying asset or an interest in the asset that will appreciate in value if
the price rises. The term “short” is used to describe a position where an investor has borrowed an asset or has an
interest in the asset (e.g., derivatives) that will rise in value when the price falls in value.

However, a long-duration strategy describes an investing approach where a bond investor focuses on bonds with
a high duration value. In this situation, an investor is likely buying bonds with a long time before maturity and
greater exposure to interest rate risks. A long-duration strategy works well when interest rates are falling, which
usually happens during recessions.

A short-duration strategy is one where a fixed-income or bond investor is focused on buying bonds with a small
duration. This usually means that the investor is focused on bonds with a small amount of time to maturity. A
strategy like this would be employed when investors think interest rates will rise or when they are very uncertain
about interest rates and want to reduce their risk.

Why is it called duration?

Duration measures a bond price’s sensitivity to changes in interest rates—so why is it called duration? A bond
with a longer time to maturity will have a price that is more sensitive to interest rates, and thus a larger duration
than a short-term bond.

What are some different types of duration?

A bond’s duration can be interpreted in several ways.

Macaulay duration is the weighted average time to receive all the bond’s cash flows and is expressed in years. A
bond’s modified duration converts the Macaulay duration into an estimate of how much the bond’s price will
rise or fall with a 1% change in the yield to maturity.

Dollar duration measures the dollar change in a bond’s value to a change in the market interest rate, providing a
straightforward dollar-amount computation given a 1% change in rates.

Effective duration is a duration calculation for bonds that have embedded options.

What else does duration tell you?

As a bond’s duration rises, its interest rate risk also rises because the impact of a change in the interest rate
environment is larger than it would be for a bond with a smaller duration. Fixed-income traders will use
duration, along with convexity, to manage the riskiness of their portfolio and to make adjustments to it.

Bond traders also use key rate duration to see how the value of their portfolio would change at a specific
maturity point along the entirety of the yield curve. When keeping other maturities constant, the key rate
duration is used to measure the sensitivity of price to a 1% change in yield for a specific maturity.