Bond duration is a measure of a bond's risk profile and is critical to understand for any investor with exposure to government or corporate bonds. Low- and intermediate-duration bonds represent two distinct risk classes for the bond investor. As such, their merits and shortcomings must be carefully evaluated.
The price of a bond and its interest rate are inversely correlated. In other words, the higher the interest rate, the lower the bond's price. However, how much a bond's price declines in response to a modest gain in its interest rate can vary widely from bond to bond. This is where duration comes in. A bond's duration is a numerical measure of its sensitivity to changes in interest rates. As a general rule, duration corresponds to the percentage loss in the bond's price as a result of a single percentage point advance in its interest rate. Duration is expressed in terms of years. So, the price a bond with a duration of two years would decline by approximately 2 percent if its interest rate goes up by one percentage point.
What Determines Duration
Broadly speaking, the longer the amount of time remaining until the bond's maturity, the higher its duration. One way to understand this relationship intuitively is to to think of a simple portfolio with two bonds. One of these bonds will expire next year and has one single annual interest payment remaining, while the other has 10 years and will, therefore, make 10 more interest payments. Should the interest rate increase by a percentage point for both -- which is another way of saying that investors demand a higher rate of compensation because they are worried about the ability of the issuers to honor interest payments -- which bond's price would take a greater hit? The second bond will suffer more because there are many more interest payments that are in jeopardy. In the case of the first bond, only a single-interest payment remains and the risk is lower as a result. Hence, the price of the second bond will take a bigger hit.
Low vs. Intermediate
While there are no universally accepted definitions of low- and intermediate-duration bonds, low duration, also known as short duration, tends to be anywhere from one to three years. Intermediate-duration bonds, on the other hand, have durations anywhere from three to 10 years. If interest rates move up, intermediate-duration bonds will suffer bigger losses than low-duration bonds. Naturally, they will also advance more if interest rates decline. In short, intermediate-duration bonds exhibit greater interest rate risk on both the up and the downside. For the novice investor, a low-duration bonds presents a better risk and reward profile. Intermediate-, and in particular long-, duration bonds are more suited for experienced investors who can manage the higher risk.
Although duration is expressed in terms of years, it does not directly correspond to the number of years remaining until the bond expires. While the remaining life of the bond and its duration are correlated, the duration is usually a smaller number than the number of years remaining until maturity. It is best to use one of the several online duration calculators to arrive at the correct figure, as manually calculating a bond's duration is tedious and time consuming.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.