Bond Duration: Interest Rate Sensitivity in Plain Terms
For educational purposes only; not investment advice.
Direct answer
Section titled “Direct answer”Bond duration is a measure of interest rate sensitivity. When people say a bond has a duration of 7, they usually mean that a small, parallel 1 percentage point rise in yield would be associated with an approximate 7% price decline, before convexity and other effects.
Duration is not the same as maturity. A 10-year bond with high coupons can have a shorter duration than a 10-year zero-coupon bond because some value is returned earlier through coupon payments.
Main types of duration
Section titled “Main types of duration”Macaulay duration is the present-value-weighted average time to receive the bond’s cash flows. Its unit is years.
Modified duration converts Macaulay duration into local price sensitivity:
ΔP / P ≈ -modified duration × Δy
Δy must be written as a decimal. A 25 basis point increase is 0.0025, not 25.
Effective duration estimates sensitivity by revaluing the bond after an up-rate and down-rate scenario. It is more appropriate for callable bonds, mortgage-backed securities, and other securities whose expected cash flows can change when rates change.
Key-rate duration splits sensitivity across curve nodes such as 2-year, 5-year, 10-year, and 30-year rates. This matters because yield curves often twist rather than move in one parallel shift.
Worked example
Section titled “Worked example”Suppose a bond is priced at 100 and has modified duration 6.5. If its yield rises from 4.00% to 4.25%, the yield change is 0.0025.
ΔP / P ≈ -6.5 × 0.0025 = -1.625%
The estimated price becomes about 98.38. If the yield falls by the same amount, the first-order estimate is about +1.625%. The actual price may differ because bond price/yield relationships are curved, so convexity matters for larger moves.
DV01 converts the same idea into money terms. A 20,000,000 portfolio with duration 5.5 has approximate DV01:
20,000,000 × 5.5 × 0.0001 = 11,000
That means a 1 basis point yield rise is estimated to reduce value by about 11,000, before convexity, credit, and curve effects.
Practical checks
Section titled “Practical checks”- Confirm whether the number is Macaulay, modified, effective, or key-rate duration.
- Use decimal yield changes in calculations.
- Check whether a bond ETF’s duration is a current portfolio estimate, not a fixed maturity promise.
- Separate interest rate duration from credit-spread duration.
- For callable or mortgage-related securities, use effective duration and model assumptions.
- Compare duration with yield, coupon, convexity, liquidity, credit quality, and expense ratio.
- Recheck dates; fund duration disclosures are often snapshots.
Common misconceptions
Section titled “Common misconceptions”Duration does not mean “years until you get your money back.” It is a time-weighted cash-flow and price-sensitivity concept.
A duration estimate is not a guarantee. Large rate moves, curve twists, embedded options, credit spreads, and trading costs can change the result.
A bond ETF with a seven-year duration does not automatically mature in seven years. Many bond ETFs continually rebalance to keep target exposure.
Coupon income can offset some price decline, but whether it offsets the decline depends on rate moves, holding period, reinvestment, credit changes, and fees.
Related topics
Section titled “Related topics”Sources
Section titled “Sources”- FINRA, “Brush Up on Bonds: Interest Rate Changes and Duration.”
- SEC, “Investor Bulletin: Interest Rate Risk — When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall.”
- Investor.gov, “Interest Rate Risk.”