What Is Bond Duration?
A lot of confusion surrounding the financial term “duration” is likely because outside of the financial world, the definition of duration is simply “the time during which something continues”.
In order to understand bond duration, forget about that other definition. Ready? Let’s first briefly review what a bond is and learn the key terms surrounding bond duration.
A Bond Is Just a Small Loan
Remember, a bond is just a fancy name for a small loan that you make to a corporate or government entity (instead of the other way around, where a corporate or government entity might issue a loan to you).
Most of the traditional loan rules apply to bonds, such as interest rates and a fixed time period.
9 Key Investing Terms You Need to Know
Here is a glossary of the key terms you need in order to understand how bonds and bond duration work. Don’t be intimidated—once you understand that bonds are very similar to traditional loans, these terms are easy to remember.
- Bond: A small loan, made by an individual, to a corporate or government entity.
- Bondholder: The individual who is loaning money to a corporate or government entity.
- Bond Duration: Bond duration is the sensitivity of a bond’s value to a change in interest rates. High duration equals high sensitivity and high risk. Low duration equals low sensitivity and low risk. We’ll go into this in more detail below.
- Bond Issuer: The corporate or government entity to whom the bondholder is loaning money.
- Coupon/Bond Yield: The profit, or return, the bondholder receives annually on their bond. Coupon/bond yield on any bond will reflect the interest rates at the time the bond is issued.
- Coupon Rate: The annual income the bondholder will receive on their bond. The annual coupon rate is calculated by interest rates. The coupon rate set in the bond agreement, but can vary depending on current interest rates.
- Par Value: This is the set value of the bond, and the amount the bondholder will be reimbursed at maturity. Oftentimes, with bonds, the par value is set to an easy-to-remember $100 or $1,000 value. This par value will never change. Try thinking of it as a bond’s wholesale price.
- Market Value: This is the price a bondholder actually pays for a bond when they purchase it. Why is this different from the par value of your bond? It’s different because the market value of the bond will rise and fall in correlation to interest rates and other factors; therefore, bonds are sold at different issue prices depending on when and where they are bought. Try thinking of it this way: if the par value is the wholesale price of a bond, then the issue price is the retail price of the bond (and retail prices can vary).
- Maturity Date: This is the date a bond matures and the bondholder gets paid back the principal bond amount (which is the par value, or wholesale price, or original investment).
What Is Bond Duration?
Bond duration is a tricky concept to understand, at first. Thankfully, bond duration follows static rules that can always be referred back to for easy understanding.
The main rule of bond duration is that the higher the duration (sensitivity to interest rates), the higher the risk and volatility. And conversely, the lower the duration (sensitivity to interest rates), the lower the risk and volatility.
Let’s take a look at why this is.
Sensitivity, Inverse Correlation, and Bond Value
If you’re here to learn about bond duration, you’ve likely already heard the famous phrase, “If interest rates rise, bond prices will drop”. But why are bonds so sensitive to interest rates, anyway? And why the inverse correlation?
At first glance, it’s slightly mystifying. If interest rates rise, wouldn’t bond prices therefore rise? But with a little more inspection, the inverse correlation makes perfect sense.
Let’s say it’s March 2021, and interest rates are at 5%. All of the bonds are set at a par value of $1,000 (wholesale price) and a market value of $1,100 (retail price), and a fixed interest rate of 5%. You buy a bond for $1,100 with a maturity date in two years, knowing that you will receive $50 every year, for a total bond yield of $100.
But interest rates suddenly rise to a staggering 10% in 2022. Now, all new bonds that are created will have a higher interest rate of 10%. So, who’s going to want to buy those old bonds with a fixed interest rate of 5%? In order to make those old bonds equally attractive to investors, the bond issuers will have to drop their market prices to $1,000.
This is a very simplified explanation of how bond duration works, and why the inverse correlation between interest rates and bond prices holds true.
Here are a few more real-life examples of bond investing and duration.
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Real-Life Examples of Bond Duration
Here are a few real-life examples of why it’s so important for bond investors to keep a close eye on fluctuating interest rates.
Bond Snapshot 1: Fixed Interest Rate
Jessica bought a $1,000 bond with a maturity of 2 years, at a fixed coupon rate of 5%.
In 1 year, Jessica will receive a $50 coupon/bond yield.
In 2 years, when her bond matures, she will receive $1,050 back, which includes:
- Her par value of $1,000
- Her coupon/bond yield of $50 (calculated with the coupon rate of 5% interest)
So, in the end, her bond had a total coupon/bond yield of $100.
Jessica’s profit is directly proportional to the coupon rate she had on her bond. Since she chose the safest kind of bond, a fixed interest rate bond, she knew exactly what she was getting into and what she would receive at the end of the 2 years. She received her coupon/yield of $100—no more, no less.
Bond Snapshot 2: Variable Interest Rate
Sam bought a $1,000 bond with a maturity of 2 years, at a variable interest rate of 5% (the current interest rate at the time of purchase).
If interest rates don’t change during that 1 year period, Sam will receive the same yield as Jessica: $50.
However, if interest rates drop to 3%, Sam’s yield will now change to $30. It’s unfortunate, but that’s the risk Sam took when he chose a variable interest rate bond.
However, instead of dropping, interest rates might rise to 7% during that year! If that’s the case, Sam’s yield has now changed to $70.
Bond Snapshot 3: Different Categories and Types of Bonds
Not all bonds are created equal. There are four main categories and four main types of bonds available on the U.S. market.
- Agency bonds: are issued by government-sponsored enterprises (GSEs) or organizations affiliated with the federal government, such as the Federal Home Loan Mortgage (Freddie Mac), Federal National Mortgage Association (Fannie Mae), or Federal Home Loan Bank.
- Corporate bonds: are issued by companies seeking a lower interest rate and more favorable terms than are offered by traditional bank loans.
- Government bonds: are issued by government authorities and collectively known as "treasuries”, or “sovereign debt” if issued by the federal government.
- Municipal bonds: are issued by states and municipalities seeking the same.
- Zero-coupon bonds: are perhaps the simplest of bonds. A zero-coupon bond does not pay a coupon rate at all. Instead, income is generated by issuing the bond at a discounted price compared to their par value. This in turn provides a profit to the bondholder at maturity, when the full par value is reimbursed. An example of a zero-coupon bond is a dollar bill issued by the U.S. treasury.
- Convertible bonds: are bonds that can be converted into stock depending on the conditions of the contract. This is attractive to some bond issuers as it allows them to sell at a lower coupon rate/higher maturity with the lure to the bondholder being that they can potentially convert that bond into stock when the stock price rises.
- Callable bonds: are considered a riskier option for bondholders. This type of bond allows the bond issuer to call back the bond before the maturity date, which often occurs when that bond is rising in value.
- Puttable bonds: are the reverse of callable bonds: this type of bond allows a bondholder to “put” or sell the bond back to the bond issuer before it has matured.
Fun Bond Facts
- Bonds are securitized as tradable assets.
- Bonds are an important instrument for governments to raise money for infrastructure and also during times of war when a government may need to raise money quickly.
- The bond market in the United States is estimated to be at $46 trillion as of 2021.
- The global bond market is estimated to be at $119 trillion as of 2021.
- The credit quality of a bond issuer and the bond’s time to maturity are two major factors in determining coupon rate.
- Some municipal bonds offer tax-free coupon income for investors.
- A bond's price may change on a daily basis based on interest rates in the current economy, similar to all publicly traded securities, where supply and demand determine price.