What is Bond Duration?

When building your portfolio, determining the appropriate allocation to fixed income requires several considerations. One major consideration for fixed income investors is interest rate risk, which is the risk that rising interest rates will cause the price of bonds to fall.

Bond duration, calculated in years, measures a portfolio's sensitivity to changes in interest rates. The duration represents the average time the bondholder must wait to receive the bond’s principal and coupon payments. A bond's time to maturity and coupon rate are two primary factors that affect its duration.

Using Bond Duration When Investing

Generally, when interest rates rise, a bond with a higher duration will be more sensitive to the change, causing their price to fall more than those bonds with a lower duration. For example, if interest rates rise by 1%, a bond or bond ETF with a five-year duration would lose about 5% of its value. The duration of a fixed income portfolio is the weighted average of the individual bonds' durations.

As mentioned, time to maturity and coupon rate both impact a bond’s duration. The longer the maturity, the higher the duration, which results in a greater interest rate risk. For example, if you are evaluating two bonds with the same coupon rate, but different maturities, the bond with the shorter maturity would repay its cost faster, resulting in a lower duration.

Conversely, when considering coupon rate, bonds with identical terms but different coupon rates will generally have different durations. The bond with the higher coupon rate will repay its costs faster, so the higher the coupon rate, the lower the duration.

Types of Duration

There are two primary methods for calculating bond duration: Macaulay duration and modified duration.

• Macaulay duration represents the weighted average time until all cash flows (coupon payments and principal) are paid. This method accounts for the present value of future bond payments and helps assess bonds independently of their maturity.
• Modified duration measures the expected change in a bond’s price in response to a 1% change in interest rates. It adjusts the Macaulay duration for interest rate fluctuations, providing a useful metric for investors concerned about rate changes.

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Managing Bond Duration

Investors can manage their bond portfolio's duration by selecting bonds with different maturities. To reduce interest rate risk, investors might choose bonds or bond ETFs with shorter maturities. On the other hand, to increase both duration and exposure to interest rate risk, investors can opt for longer-term bonds.

Longer-term bonds typically offer higher yields because holding bonds for extended periods increases uncertainty around interest rate changes and inflation. This heightened risk is compensated for by higher yields.

Since forecasting interest rate changes can be challenging, many investors use bond indices to benchmark their portfolio’s duration. For example, the Bloomberg U.S. Aggregate Bond Index has an average duration of approximately six years, allowing investors to align their portfolios accordingly.

Depending on your investment objective and time horizon, your tolerance for interest rate risk may vary. Since interest rates do not always move in parallel, adjusting your holdings may depend on multiple factors, including interest rate environments.

Limitations of Duration

While duration is a valuable tool for analyzing the interest rate sensitivity of a bond portfolio, it doesn’t offer a complete risk profile. Duration does not consider the credit quality of the bonds or whether portfolio holdings have been adjusted over time. Additionally, duration is measured at a specific point in time, meaning that changes in interest rates or matured bonds could affect the accuracy of the measurement. Different bonds may also react differently to interest rate changes, making regular monitoring of portfolio duration essential. Actively managed strategies that target specific duration ranges can also help maintain portfolio balance.

The Bottom Line

Investing in fixed income involves understanding the risks that can impact yields. Key risks include interest rate risk, where changing rates can affect bond prices, and credit risk, which refers to the potential for issuers to default on payments. Bond duration helps measure the sensitivity of bonds to these risks, guiding investors in their search for higher yields or lower prices.

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