Each bond takes a particular time to pay back the interest liability and the principal investment amount. During this time, the bond, its values and returns can be affected by various factors. The bond’s sensitivity can be measured, and one such measuring matrix is the bond duration.
Defining Bond Duration: How It Works?
In simpler terms, bond duration shows the time a bond will take to return the bond price through different cash flows. However, it can be confused with the maturity period of the bond, and hence, a more structural definition is required.
The prevailing market rates greatly influence bond prices. If the interest rate in the market rises, the price of the bond will fall as it will generate lower returns. If the market rate increases, the bond price will shrink as it will generate lower returns than new bonds issued at the new market rate.
In short, the bond price moves in the other direction of the market rate’s movements. Duration shows how much the bond price will move.
Example
Suppose you are invested in a bond with 1o year duration. If the market rate increases by 1%, the bond will lose 10% of its value.
Time to Maturity
The greater the maturity period, the bigger the interest risk and duration. Take two bonds with similar yields and prices. The bond with a shorter remaining maturity period will repay the cost faster than the one with a longer maturity period.
Coupon Rate
Two bonds with similar features can have different durations if the coupon rates are different. The bond with the higher coupon rate will repay the investors quicker than the bond with a lower rate. Interest risk will be lower as well for high-rate bonds.
Types of Bond Duration
There are two types of bond durations:
- Macaulay Duration: This type shows the weighted average time a bond takes to repay all cash flows. It presents the duration in years.
- Modified Duration: This type shows the change in the bond price with a 1% change in the interest rates. It presents the duration in percentage.
Significance of Bond Duration
Here is what bond duration signifies:
- High bond duration = higher interest risk + more price movements
- Low bond duration = lower interest risk + lesser price movements
In theory, the bond duration can help assess the risk factors and can be used while determining investment strategies.
Wrapping Up!
Credit risk and interest risk are two important factors for bond investments. Duration can help assess both risks. It can play a critical role in primary investment strategies and decisions to hold the bond till maturity or sell it.
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FAQs About What is Bond Duration?
1. What is the difference between bond duration and maturity?
Maturity is the time available for repayment, while duration shows the bond’s sensitivity to changes in interest rates.
2. Do zero coupon bonds have duration?
Since zero coupon bonds do not pay any interest, the maturity and the duration can be considered the same.
3. What factors influence bond duration?
Coupon rates and time to maturity can influence the bond duration.
