Duration is a measure of a bond’s interest rate sensitivity expressed in years.
Generally, the longer the duration, the more sensitive the bond’s price is to interest rate changes and the higher the price volatility it faces. On the contrary, bonds with shorter duration are less sensitive to interest rate change and subject to lower price volatility.
There are three common types of duration and “Effective Duration” is most commonly used. Duration measures the time it takes to repay the investor and it is not equal to bond maturity. Duration is usually shorter than bond maturity as bonds pay coupon interest. In addition to maturity and coupon rate, “Effective Duration” also takes into account the embedded call features and yield-to-maturity.
For instance, if rates were to rise 1%, a bond portfolio with a duration of 10 years would be expected to lose 10%. By contrast, a 1% rate hike would cause a portfolio with a duration of 5 years to lose 5% of its value.
Therefore, if interest rates are expected to rise, a prudent strategy would be to hold bonds or bond funds with shorter duration as the bond prices are less sensitive to changes in interest rates. Conversely, it may make more sense to focus on longer-duration bonds or bond funds should interest rates be expected to fall.
This example is for illustration purposes only. Investors should always be mindful about the market volatility, and fully understand the investment risks before proceeding further.