If rates were to fall 2%, the bond’s value would also rise by approximately twice as much (18%). Therefore, in our example above, if interest rates were to fall by 1%, the 10-year bond with a duration of just under 9 years would rise in value by approximately 9%. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration. Duration measures the percentage change in price with respect to a change in yield.
This hypothetical example is an approximation that ignores the impact of convexity we assume the duration for the 6-month bonds and 10-year bonds in this example to be 0.38 and 8.87, respectively. *A simultaneous change in interest rates across the bond yield curve.
Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier. Why is this so? Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do. The chart below shows how a bond with a 5% annual coupon that matures in 10 years (green bar) would have a longer duration and would fall more in price as interest rates rise than a bond with a 5% coupon that matures in 6 months (blue bar). Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Generally, bonds with long maturities and low coupons have the longest durations. The larger the coupon, the shorter the duration number becomes. When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate. For example, if rates were to rise 1%, a bond or bond fund with a 5-year average duration would likely lose approximately 5% of its value.ĭuration is expressed in terms of years, but it is not the same thing as a bond's maturity date. Investment professionals rely on duration because it rolls up several bond characteristics (such as maturity date, coupon payments, etc.) into a single number that gives a good indication of how sensitive a bond's price is to interest rate changes. While no one can predict the future direction of interest rates, examining the "duration" of each bond, bond fund, or bond ETF you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates. Using a bond's duration to gauge interest rate risk
The degree to which values will fluctuate depends on several factors, including the maturity date and coupon rate on the bond or the bonds held by the fund or ETF. Similarly, if you own a bond fund or bond exchange-traded fund (ETF), its net asset value will decline if interest rates rise. If rates rise and you sell your bond prior to its maturity date (the date on which your investment principal is scheduled to be returned to you), you could end up receiving less than what you paid for your bond. Bond prices and interest rates move in opposite directions, so when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value. However, Treasury bonds (as well as other types of fixed income investments) are sensitive to interest rate risk, which refers to the possibility that a rise in interest rates will cause the value of the bonds to decline. Credit risk refers to the possibility that the company or government entity that issued a bond will default and be unable to pay back investors' principal or make interest payments.īonds issued by the US government generally have low credit risk. The most common and most easily understood risk associated with bonds is credit risk. While bonds have historically been less volatile than stocks over the long term, they are not without risk. There is a common perception among many investors that bonds represent the safer part of a balanced portfolio and are less risky than stocks.
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