Bond duration is the length of time it takes for a bond to pay back an investor.
Think of a bond as a loan, similar to a mortgage. If the bond will take 10 years to pay back the money borrowed, it has a duration of 10 years.
Those payments take two forms, the coupon and the principal. The coupon is the interest paid the investor on the amount lent out.
The principal is the actual loan to be returned over that period of time. While normally measured in years, there are short-term bonds with durations of less than a year.
Likewise, some bonds can have a duration of decades. U.S. government Treasury bonds, for instance, are typically issued for 30 years.
Corporate bonds can be even longer and some companies and foreign governments offer so-called “century bonds” that have a duration of 100 years.
Bond duration matters because the longer a bond takes to pay back, the more likely that it will be sensitive to a change in interest rates.
That’s because the price of a bond is inversely related to its duration. If a bond has a long duration, say decades, it is more likely to fall in price as interest rates go up.
In a sense, interest rates don’t matter if you hold a bond to its expiration. Unless the issuer defaults, you will be paid back the principal and interest as agreed.
If you need to sell that bond, however, things change. A rising interest rate means investors could buy a newer bond of the same duration that pays more in interest than your existing bond.
Another investor will buy your lower-paying bond, but the buyer will expect a discount to compensate for the difference in the coupon value of your older bond.
In fact, a rapid, uncontrolled rise in the interest rate can damage the value of many billions of dollars worth of existing bonds.
That’s why central banks make interest rate adjustments slowly and methodically, communicating the direction of rates well in advance.
An investment manager can calculate the average duration of an entire portfolio of bonds. The manager’s job is to hold bonds that pay reasonable interest income while managing the risk of falling bond prices.
A third kind of risk, the default risk, also can affect bond prices. Default risk is the measure of the likelihood that the bond issuer might not pay back the borrowed money.
Investors should carefully consider all risks when investing in bonds.
Often, bonds are depicted as “safe” investments compared to stocks. Nevertheless, there is risk if a bond investor fails to take into account default risk and interest rate risk.
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