Duration and Bond Interest Rate Risk
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Duration and Bond Interest Rate Risk
Another risk that bond investors face is interest rate risk—the risk that rising interest rates will make their fixed interest rate bonds less valuable.
Things To Know
- A bond’s duration will determine how its price is affected by interest rate changes.
How it works
To illustrate this, let’s suppose you bought a $1,000 par value bond with a 10-year maturity and a 6 percent coupon rate. You will earn 6 percent of $1,000, or $60, each year that you own the bond. Let’s further assume that after one year, you decide to sell it, and at that time, new bonds are being issued with 7 percent coupons. Investors can choose between your 6 percent bond and a new 7 percent bond. To entice someone to buy your bond, you will to have to discount its price so that the new owner will earn the same $60, but will have paid less than $1,000 to buy it, thus raising his or her yield closer to 7 percent.
The reverse is also true. Using the example above, let’s assume that when you sell your bond, new bonds are being issued with 5 percent coupons. Investors can choose between your 6 percent bond and a new 5 percent bond. Comparatively, your bond is now much more attractive. An investor will be willing to pay more than $1,000 to earn 6 percent rather than 5 percent.
How duration helps investors
Duration is the tool that helps investors gauge these price fluctuations that are due to interest rate risk. Duration is expressed as a number of years from the purchase date. In simple terms, a bond’s duration will determine how its price is affected by interest rate changes. In other words, if rates move up by one percentage point—for example, from 6 percent to 7 percent—the price of a bond with a duration of 5 years will move down by 5 percent, while a bond with a duration of 10 years will move down by about 10 percent. You will notice that all components of a bond are duration variables. That is, the bond’s duration, coupon, and yield-to-maturity, as well as the extent of the change in interest rates, are all significant variables that ultimately determine how much a bond’s price moves.