It's almost impossible to hear or read about the bond markets without coming across the word "duration." But what does this term mean? And how does it affect your savings?
First, it's important to understand how interest rates and bond prices are related. The key point to remember is that rates and prices move in opposite directions. When interest rates rise, the prices of traditional bonds fall, and vice versa. So if you own a bond that is paying a 3% interest rate (in other words, yielding 3%) and rates rise, that 3% yield doesn't look as attractive. It's lost some appeal (and value) in the marketplace.
Duration is a way of measuring how much bond prices are likely to change if and when interest rates move. In more technical terms, duration is measurement of interest rate risk.
Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise.
How Duration Affects the Price of Your Bonds
So how does this actually work? As a general rule, for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration.
For example, if a bond has a duration of five years and interest rates increase by 1%, the bond's price will decline by approximately 5%. Conversely, if a bond has a duration of five years and interest rates fall by 1%, the bond's price will increase by approximately 5%.
Understanding duration is particularly important for those who are planning on selling their bonds prior to maturity. If you purchase a 10-year bond that yields 4% for $1,000, you will still receive $40 dollars each year and will get back your $1,000 principal after 10 years regardless of what happens with interest rates. If, however, you sell that bond before maturity (or if you are invested in a fund that buys and sells bonds while you own it) then the price of your bonds will be affected by changes in rates.
Why Duration Is Helpful
Because every bond and bond fund has a duration, those numbers can be a useful tool that you and your financial professional can use to compare bonds and bond funds as you construct and adjust your investment portfolio.
If, for example, you expect rates to rise, it may make sense to focus on shorter-duration investments (in other words, those that have less interest-rate risk). Or, in this sort of environment, you may want to focus on bonds that take on different types of risks, such as high yield bonds, which are less affected by movements in interest rates.
It's also important to remember that duration is only one of many factors that could affect the price of your bonds. And that's why we think it's important to work with a financial professional who can help you construct a portfolio that's built to meet your individual goals.