If you own bonds or bond funds, there is a number you should know – duration. Although stated in years, duration is not simply a measure of time. Instead, it reflects how much the price of your bond investment is likely to change when interest rates move up or down. The higher the duration number, the more sensitive your bond investments are interest-rate changes.
Interest rates are at all-time lows. Many economists predict that interest rates are not likely to get much lower and will eventually rise. If that happens, then outstanding bonds, especially those with low interest rates and high duration, likely would decline in value significantly.
How Duration Affects Bond Prices
Many factors impact bond prices, one of which is interest rates. A principle of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is known as interest-rate risk. But some bonds are more sensitive to interest-rate changes than others. Duration risk is the name economists give to the sensitivity of a bond’s price to a one-percent change in interest rates.
The higher a bond’s duration, the greater its sensitivity to interest-rate changes. That is, the price of bonds with a greater duration react more dramatically to interest rate changes. If you hold a bond to maturity, you can expect to receive the par (or face) value of the bond when your principal is repaid (unless the company goes bankrupt or otherwise fails to pay). But if you sell before maturity, the sale price would be affected by the prevailing interest rates and duration. For instance, if interest rates were to rise, as expected, bonds higher durations stand to lose much more value than those bonds with lower durations.
A number of variables affect the calculation of a bond’s duration. Those include: how much interest a bond pays during its lifespan, as the bond’s call features and yield, and maturity date. A bond fund’s duration can be found in the fund’s Fact Sheet. But identifying the duration of an individual bond can be more difficult. Start by asking your investment professional or the bond’s issuer. There are also online calculators available that compute an individual bond’s duration.
Low Duration Does Not Mean Low Risk
To be clear, duration merely reflects how a bond investment will react to interest-rate changes. A low duration number does not mean low risk. But bond investors should be aware of the level of exposure their portfolio has to duration risk. A careful review of your portfolio can help you determine whether your broker or financial advisor has improperly structured your bond portfolio.