Question: I purchased some bonds and was told their duration is five years. What exactly does that mean?

Faye Schwartz

Answer:

Dear Faye,

Duration refers to the change in a fixed income security -- such as your bonds -- that will come about if there's a 1% change in interest rates.

Duration is always given in years. Let's look at an example... You were told that your bonds have a 5-year duration, that means the bonds will decrease in value by 5% if interest rates rise 1%. On the other hand, your bonds will increase in value by 5% if interest rates fall 1%.

Duration vs. Maturity

Many investors confuse duration with maturity -- or believe them to be the same thing. Not so.

Unlike maturity, duration takes into account interest payments that occur while you're holding the bond. To be more technical in our explanation, duration is a weighted average of the maturity of all income from a bond or portfolio of bonds.

Note: The duration years on any bond that pays coupons will be less than the maturity years because some of the payments are going to come before the maturity date.

How to use duration

You can use duration to measure the volatility of a bond.

Generally, the higher the duration number (the longer an investor needs to wait for the bulk of the payments), the more its price will drop as interest rates go up.

On the other hand, if interest rates fall, a bond with a long duration will be appealing because the bond's price will increase more than comparable bonds with shorter durations.

Duration is a rather complicated mathematical concept. If you have more questions on the topic, be sure to write to us again.

Good luck!