Bond Duration

The rate-sensitivity gauge

A bond's price moves in the opposite direction to interest rates: rates up, price down, and vice versa. Duration compresses that sensitivity into a single number. Read it as a multiplier: a duration of 7 means a one percentage point rise in rates knocks roughly 7% off the price, and a one point drop adds roughly 7%.

The same number works for bond funds and ETFs, which simply average the durations of everything they hold. That makes duration the single most useful figure on any bond fund's fact sheet: it tells you, before you buy, how hard the fund will swing when rates move.

Duration is not term to maturity

It is natural to assume a 10-year bond has a duration of 10, but it does not. A typical 10-year coupon bond has a duration of about 8, because you do not wait ten years for all your money: coupons arrive every six months along the way, and those earlier dollars pull the average forward. Duration is, at heart, the average time you wait to be paid, with each payment weighted by its size.

The exception proves the rule. A strip bond pays nothing until maturity, so there is nothing to pull the average forward: a 10-year strip has a duration of essentially 10, the maximum possible for its term, which is why strips are the most rate-sensitive bonds you can buy.

What makes duration longer or shorter

Three ingredients set a bond's duration, and all three follow from the "average waiting time" idea:

• Longer maturity means longer duration: the big final payment sits further away.
• Lower coupons mean longer duration: with less cash arriving early, more of the bond's value waits at the end.
• Lower yields mean longer duration: when the yield to maturity is low, distant payments are discounted less and carry more weight in the average.

2022: the year duration mattered

For decades duration was an abstraction; 2022 made it visceral. As the Bank of Canada raised its policy rate from 0.25% to 4.25% in a single year, long-term government bond ETFs, with durations around 16, lost roughly 25% of their value. Short-term bond funds, with durations near 2 or 3, barely moved. Same issuer, same credit quality, same "safe" asset class: duration was the entire difference.

The lesson is not that long bonds are bad. Investors who hold long durations are taking a position that pays off handsomely when rates fall. The lesson is that a bond fund's rate risk lives in its duration, and 2022 punished everyone who had not looked at the number.

Using duration in practice

The most practical use is matching duration to your time horizon. If you need the money in about 7 years, a portfolio with a duration near 7 largely insulates you: if rates rise, prices drop, but coupons and maturing bonds reinvest at the new higher rates, and by year 7 the two effects roughly cancel. Professionals call this immunization; in plain words, it means the money you need on a given date is not hostage to what rates do in the meantime.

Two refinements you may see on fact sheets. Technically, Macaulay duration is the average waiting time in years and modified duration is the slightly adjusted version used to estimate price moves; fund documents almost always show modified duration, and for everyday purposes the two are close enough to treat as one idea. And the straight-line estimate errs in your favour: for big rate moves, prices fall a bit less than duration predicts and rise a bit more, a curvature effect called convexity.