Bonds & Interest Rates · Pro · 4 min

Understanding duration

You can use a bond's or fund's duration to estimate how much its price changes when interest rates move, and name the limits of that estimate.

One number to check

Two bond funds, both investing in high-quality government bonds. Rates rise by one percentage point. One fund loses 2%, the other 15%.

The difference was visible in advance, in a single number on each fund's fact sheet: its duration. It is one of the most useful numbers in bond investing, and one of the least read. This lesson explains what it measures and how to use it.

Price move ≈ duration × rate move

Duration measures how sensitive a bond's price is to changes in interest rates. FINRA gives the practical rule: for every one percentage point change in interest rates, a bond's price moves in the opposite direction by roughly its duration number.

Duration 5, rates rise 1 point: the price falls about 5%.
Duration 5, rates fall 1 point: the price rises about 5%.
Duration 5, rates rise 0.5 points: the price falls about 2.5%.

FINRA stresses that although duration is stated in years, it is not simply a measure of time. It tells you how much the price is likely to fluctuate. The same rule works for bond funds, whose fact sheets usually state an average duration for all holdings.

What raises or lowers it, according to FINRA:

Longer maturity, higher duration. More payments lie far in the future.
Higher coupon, lower duration. More of the value comes back early through coupons.

A zero-coupon bond has a duration equal to its maturity, because everything is paid at the end.

The rule is an estimate. It works best for small rate moves. For large moves, and for bonds whose payments can change, such as callable bonds or mortgage-backed securities, the real price change can differ. FINRA also points out that a low duration does not remove other risks, such as credit or inflation risk.

−2% · −7% · −15%

Three fictional bond funds, all holding high-quality bonds, differ only in duration. Rates rise by one percentage point.

Short-term fund, duration 2: about −2%.
Medium-term fund, duration 7: about −7%.
Long-term fund, duration 15: about −15%.

On 20,000, that is a loss of about 400 in the short fund and about 3,000 in the long one. When rates fall instead, the long fund gains the most. Duration cuts both ways.

Common mistakes

Reading duration as a holding period. It is a measure of sensitivity.
Choosing a long-duration fund for safety. It has the largest price swings.
Applying the rule to huge rate moves. It is a rough estimate for small changes.
Ignoring other risks. Low duration says nothing about credit quality.

The takeaway

Duration estimates price sensitivity: a duration of 5 means roughly 5% price change per 1 point move in rates, in the opposite direction.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the bond fund that would lose most if rates rise by one point.

Tap the chart.

The higher the duration, the more sensitive the price. A duration of 15 means roughly −15% for a one-point rise.
2A bond fund has a duration of 6. Rates fall by half a percentage point. What happens to its price, roughly?

Duration × rate change: 6 × 0.5 = 3, and since rates fell, the price rises.
3What does FINRA stress about duration being stated in years?

Duration is expressed in years, but its practical use is as a measure of price sensitivity.
4Which bond has the higher duration, all else equal?

FINRA: the longer the maturity, the higher the duration; the higher the coupon, the lower the duration.

of 4 correct.