Question

What is duration of bond? Why is it important?

Answer 1

Duration is a way of measuring how much bond prices are likely to change if and when interest rates move. In more technical terms, duration is measurement of interest rate risk. If a bond has a duration of 6 years, for example, its price will rise about 6% if its yield drops by a percentage point (100 basis points), and its price will fall by about 6% if its yield rises by that amount.

A bond's duration changes with time and as its price and yield change, however Duration measures the time it takes to recover half the present value of all future cash flows from the bond. The discount rate for calculating the present value of the cash flows is the bond's yield. So as a bond's price and yield change, so does its duration.

Understanding duration is particularly important for those who are planning on selling their bonds prior to maturity. If you purchase a 10-year bond that yields 4% for $1,000, you will still receive $40 dollars each year and will get back your $1,000 principal after 10 years regardless of what happens with interest rates. If, however, you sell that bond before maturity (or if you are invested in a fund that buys and sells bonds while you own it) then the price of your bonds will be affected by changes in rates.

Duration is important

Because every bond and bond fund has duration, those numbers can be a useful tool that you and your financial professional can use to compare bonds and bond funds as you construct and adjust your investment portfolio.

If, for example, you expect rates to rise, it may make sense to focus on shorter-duration investments (in other words, those that have less interest-rate risk). Or, in this sort of environment, you may want to focus on bonds that take on different types of risks, such as the Strategic Income Opportunities Fund, which is less affected by movements in interest rates.

It's also important to remember that duration is only one of many factors that could affect the price of your bonds. And that's why we think it's important to work with a financial professional who can help you construct a portfolio that's built to meet your individual goals.

By providing a way to estimate the effect of certain market changes on a bond's price, duration can help you choose investments that might better meet your future cash needs. Duration also helps income investors who want to take on minimal interest rate risk (that is, they believe interest rates might rise) understand why they should consider bonds with high coupon payments and shorter maturities.