Financial Quotient

What is duration?

WHAT DOES IT MEAN?

Duration, usually expressed as a number of years, measures how long an investor has to wait before the purchase of a bond is repaid through its regular coupon payments and the final face-value payment returned at maturity.

Calculating duration takes into account the bond's present value, yield, coupon and time to maturity.

Duration also serves as a gauge for the price sensitivity of a bond or a bond portfolio to a change in interest rates.

If interest rates change by 1 per cent, a bond's price would change by about 1 per cent in the opposite direction for each year of duration. For instance, for a bond with a five-year duration, a 1 per cent increase in interest rates would see a decrease in value by 5 per cent, and vice versa.

WHY IS IT IMPORTANT?

Duration is an important tool for bond investors when managing risk.

Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest rate risk (rate fluctuations). The longer the duration, the more a bond's value increases or decreases because of interest rate changes, and the greater the interest rate risk or reward.

For example, if an investor expects interest rates to rise over a period of time, buying long-duration bonds would be less appealing as they would see a fall in bond price compared with shorter-duration bonds.

Calculating duration takes into account the bond's present value, yield, coupon and time to maturity.

IF YOU WANT TO USE THE TERM, JUST SAY:

To minimise interest rate risks when investing in a bond, one could seek to buy bonds with high coupon payments, a short term to maturity or a shorter duration, as that would make the bond or portfolio less sensitive to changes in interest rates.

A version of this article appeared in the print edition of The Sunday Times on October 08, 2017, with the headline 'What is duration?'. Print Edition | Subscribe