What does "duration" of a bond mean?
The "duration" of a bond is a metric that indicates the sensitivity of the bond price compared to changes in interest rates. It provides the average weighted maturity (in years) of the bond's cash flows and offers insight into how the bond's value reacts to interest rate movements.
Duration is often used by investors to assess interest rate risk. A high duration means that the bond price will react strongly to interest rate changes, while a low duration means that the bond price is less sensitive to interest rate fluctuations. The rule of thumb is that if the duration is 5 (the average weighted maturity (in years)) and the interest rate rises by 1%, the value of the bond decreases by 5%.
For the connoisseurs, there are two commonly used forms of duration:
- Macaulay duration: This is the weighted average time (in years) needed to recoup the present value of all future cash flows of the bond. It is often used for theoretical calculations and is useful when comparing bonds with different maturities and coupons.
- Modified duration: This is an adjusted version of the Macaulay duration that indicates how the bond price changes percentage-wise with a 1% change in interest rates. It is more practical for estimating interest rate sensitivity in investment portfolios.
In essence, duration helps investors to better understand and manage the interest rate risk of a bond.