Bond Duration
Duration is a measure of a bond’s price sensitivity to relatively small interest rate changes. A bond’s duration expresses the percentage change in the price of a bond that would result from a 1% change in yield. A bond with a high duration is more sensitive to interest rate changes than a bond with a low duration. For example, if a bond has a duration of 5, its price will roughly decrease 5% with a 1% increase in interest rates, while a bond’s price will decrease 10% if it has a duration of 10. In other words, duration measures the risk of price fluctuations based on interest rate changes.
Another way of thinking about duration is to think about when the principal and interest will be paid to the investor. The more interest and principal that is paid later in the life of the bond, the more sensitive the bond is to interest rate changes. Bonds with small coupon rates pay a greater portion of the payments at the end of the bond’s life than bonds with greater coupon rates, so small bond coupon rates have higher durations than bonds with larger coupon bonds. Zero coupon bonds have the highest duration among bonds of a comparable maturity because all the payments are made at maturity. Additionally, longer-term bonds take longer until the interest and principal is paid back so they have higher durations than shorter-term bonds. This makes sense because the longer the term of a bond, the more time there is for interest rates to change. To summarize, two factors influence a bond’s interest rate volatility: the coupon rate and the time to maturity. A bond with a low coupon rate will have a higher duration tha