Bond Duration: The Number That Tells You How Much a Rate Move Will Hurt

Two government bonds. Same issuer, same credit quality, similar yield. Interest rates rise by one percentage point.

One falls about 2%. The other falls about 18%.

The difference is duration, and it is the single most useful number in fixed income - because it turns interest rate risk from something you experience afterwards into something you can measure beforehand.

What it measures

Duration answers a specific question: if yields move by one percentage point, roughly how much will this bond's price move?

It is expressed in years, which is a source of confusion, because it is really a sensitivity measure. The units come from how it is calculated - a weighted average of the time until each of the bond's payments arrives, with each payment weighted by its present value.

The intuition: money you receive far in the future is more affected by a change in discount rates than money you receive soon. A bond whose payments are concentrated far out is therefore more sensitive than one paying steadily along the way.

Using it

The practical rule is simple.

Price change is approximately minus duration times the change in yield.

A bond with duration 7, yields rise 1 percentage point: about a 7% fall. A bond with duration 3, yields fall 0.5 points: about a 1.5% gain. A bond with duration 18, yields rise 1 point: about an 18% fall.

That last one is not hypothetical. Long-dated government bonds carry high duration, and holders of thirty-year debt have experienced losses of that magnitude from rate moves alone - on instruments with no credit risk whatsoever.

This is worth stating plainly, because "government bonds are safe" is true about default and says nothing about price. A default-free bond can lose a third of its value if rates rise enough. The safety refers to getting your money back at maturity, not to what happens in between.

Duration versus maturity

They are often conflated and they are not the same thing.

Maturity is when the final payment arrives.

Duration accounts for all the payments, including the ones before maturity.

A ten-year bond paying a healthy coupon returns money to you throughout that decade. Some cash arrives in year one, more in year two, and so on. The weighted average time to receive it is well under ten years - so its duration might be seven or eight.

A zero-coupon bond pays nothing until the end. All the money arrives at maturity, so duration equals maturity exactly. These are the most rate-sensitive bonds available for a given maturity.

The general rules follow from this:

• Longer maturity means higher duration
• Lower coupon means higher duration, because less money comes back early
• Lower yield means higher duration, because distant payments carry more weight in present value terms

That third rule has an uncomfortable implication. When yields are very low, duration is high - so portfolios are most sensitive to rising rates precisely when rates have the most room to rise.

What duration misses

Duration assumes a straight-line relationship between yield and price. The real relationship is curved.

That curvature is called convexity, and it works in the holder's favour for conventional bonds. When yields fall, prices rise slightly more than duration predicts. When yields rise, prices fall slightly less.

For small moves this is negligible. For large moves it matters, and duration alone will consistently mis-estimate both directions in the same helpful way.

Convexity is not always positive. Bonds that can be repaid early by the issuer - callable bonds, and mortgage-backed securities where homeowners refinance - can exhibit negative convexity. When rates fall, the borrower repays early, so the holder does not get the full price gain they would otherwise. Upside is capped; downside is not. Anyone holding mortgage-related debt is holding this characteristic whether or not they have thought about it.

Where it gets used

Comparing bonds. Two bonds with the same yield and different durations are not the same investment. The higher-duration one is taking substantially more interest rate risk for the same compensation.

Sizing risk in a portfolio. A bond fund publishes its average duration. That number, multiplied by a plausible rate move, gives you a direct estimate of what you could lose. It takes seconds and most holders never do it.

Matching liabilities. Pension funds and insurers owe money at known future dates. Matching the duration of assets to the duration of those obligations means both move together when rates change, which neutralises the risk. This is a large part of why institutional demand for very long-dated bonds exists at all.

Expressing a view. Someone expecting rates to fall extends duration to capture more of the gain. Someone expecting rates to rise shortens it. This is the main lever in active bond management.

The limits

It assumes a parallel shift. Duration describes what happens if all yields move by the same amount. In practice the curve twists - short rates can rise while long rates fall. Duration will not capture that.

It is a snapshot. Duration changes as time passes and as yields move. It is not a fixed property.

It says nothing about credit. A corporate bond has both interest rate risk and default risk. Duration measures the first and is silent on the second.

The bottom line

Duration converts a vague worry - "what happens to my bonds if rates rise?" - into an arithmetic answer. Multiply duration by the expected rate move and you have your estimate.

It is published for every bond fund, it takes one multiplication to use, and it explains why two apparently similar holdings can behave so differently in the same market. For anyone holding fixed income in any form, it is the number worth knowing.

This article is educational and is not financial advice. Bond prices and yields move inversely and are subject to interest rate risk.