Duration is a measure of bond price sensitivity to changes in interest rates, and it’s a risk every bond investor is exposed to. Duration is important for bondholders and becomes increasingly so when interest rates are rising.
There are different types of duration; the most common are Macaulay and modified duration. There’s also effective duration, which is used for bonds with embedded options, like a call feature.
Duration can be quoted for individual bonds as well as for a bond fund or ETF.
Macaulay duration
Macaulay duration, named after Canadian economist Frederick Macaulay (1882-1970), estimates the number of years until a bond investor will be repaid the bond’s price. It is a weighted average period of time during which all cash flows are received by the bondholder.
A weight is assigned to the present value of each coupon payment (cash flow) at the applicable interest rate, for the life of the bond.
The Macaulay duration of a traditional bond will always be less than its maturity period.
Modified duration
Modified duration is an extension of Macaulay duration and measures the change in bond price for a 1% change in interest rates.
This is a more precise measure of bond price sensitivity and is quoted as a percentage. In order to calculate modified duration, the Macaulay duration is calculated first, since Modified Duration = Macaulay Duration / (1 + Yield To Maturity).
Why does duration matter?
Duration is important because of its impact on fixed income returns. Investors need to realize that while long duration may be a boon in times of declining rates, it will be a source of considerable pain as interest rates rise. The duration of bond investments, be they individual bonds or a bond fund, is ultimately a key driver of returns. Investors need to be prepared for the upside and downside of long duration fixed income holdings.