Bond duration: what it is and how to use it

Duration is the second number, after the yield, to look at before choosing a bond. It answers a simple question: if interest rates change, how much does the price of my bond change?

Two bonds can offer the same yield and still behave very differently when the market moves. Duration is what tells them apart, which is why it belongs next to the yield in every comparison.

Two kinds of duration

Macaulay duration is the average maturity of the bond's cash flows (coupons and repayment), weighted by their present value. It is measured in years and is always equal to or shorter than the remaining life of the bond: the coupons arrive before the final repayment.

Modified duration is derived from the first (you divide it by 1 + yield) and directly measures the sensitivity of the price to interest rates. It is the one 10BONDS uses and the one you find in our sliders.

In everyday use, when people say "duration" they usually mean the modified one, because it translates directly into a percentage change in price.

The rule of thumb

With a modified duration of D years, if market yields rise by one percentage point the price falls by about D%. If they fall by one point, the price rises by about D%.

• Duration 2: a 1% rise in rates costs about 2% of the price.
• Duration 5: about 5%.
• Duration 10: about 10%.

Example: a 3% bond maturing in 5 years with a yield of 4.13% has a Macaulay duration of about 4.7 years and a modified duration of about 4.5. The rule works well for small changes; for large changes convexity comes into play, which makes price rises a little larger than price falls.

The rule works in both directions, so duration is not only a measure of risk: a long-duration bond loses more when rates rise, but it also gains more when rates fall.

What lengthens or shortens duration

• Maturity: the further away it is, the longer the duration.
• Coupon: high coupons return more money earlier, so they shorten the duration. A zero-coupon bond has a Macaulay duration equal to its remaining life.
• Level of yields: higher yields shorten the duration slightly.

This is why two bonds with the same maturity can have different durations: the one with the higher coupon pays back more of your money along the way, and is therefore a little less exposed to changes in rates.

Duration and investment horizon

If you already know when you will need the money, choosing a duration close to that horizon limits the risk: if rates rise, the price falls but you reinvest the coupons at higher rates, and the two effects tend to offset each other. If the horizon is short and the duration long, a rise in rates may force you to sell at a loss.

You can compare bonds by duration band, for example around 2 years, around 5 years or around 10 years, using the duration slider in the bond finder.

What duration does not measure

Duration measures only interest rate risk. It says nothing about the strength of the issuer: for that you need the rating and the spread, explained in the guide on credit risk. And it does not work well for floating-rate or callable bonds, which react to interest rates in a different way.

Duration is also a snapshot: as time passes and as yields move, it changes. A bond bought with a duration of 5 will have a shorter duration a year later.

Read it together with the yield to maturity and the rating, and you have the three numbers that describe most of what matters in a bond.

Find your 10 bonds: set the duration you need and the yield you are looking for.