Bond Duration

Bond duration is a term that would appear to refer to the length of time it takes for the bond to mature, and at least in part, it is but this is also one area were the more complex aspects of owning bonds is found.

Duration is actually part of the bond's asset, and refers to measuring the sensitivity of the asset's price to changes in interest rates. The length of time the bond takes to be repaid is one of the factors involved in computing the bond duration, but from that point definitions of bond duration and derived quantities vary considerably. But possibly the most common definition of duration most experts use in Macaulay duration.

The way duration is arrived using Macaulay method at is by using a ratio of the percentage reduction in the price of the bond to the percentage increase in the redemption yield of the bond. The equation for doing this is not for the faint of heart but it does allow for small changes in quantities. The number of years become the duration units, and the range of duration is always between 0 years and the time to maturity of the bond.

For those who feel the need or desire to actually use the Macaulay it can be easily found on the internet but what is more important to understand is that Macaulay duration is the weighted average maturity where the relative discounted cash flow is computed in each period. The idea is to have tools to predict interest rate risk by using either the Macaulay-Weil duration method which uses zero-coupon bond prices as discount factors, or a perhaps more practical method which uses the bond's yield to maturity to arrive at the discount factors.

Bond duration is a key factor when it is remembered that bonds are not risk free. The reverse relationship between interest rates and bond prices is one aspect of bonds that cannot be ignored and the larger the duration numbers are the higher the risk-rate becomes. Understanding the credit risk represented by defaults as well as the interest rate risk allows the investor to make better decisions. And while bond duration is a standard data point that is usually part of the information provided with bonds and bond mutual funds understanding the concept is essential to making good investments.