Understand Interest-Rate Risk

Bond prices on the secondary market move in the opposite direction of interest rates. When rates fall, bond prices rise. When rates rise, bond prices fall. To determine how dramatic a fund's rises and falls might be, check out its duration.

What creates interest-rate risk?

Duration—or interest-rate risk—boils down to the three risk factors of bonds: maturity, the cash flows from coupons, and current interest rates. Sound confusing? Think of a bond as a pro-basketball player's contract. In negotiating his first contract, a top draft pick wants a salary that will stay competitive with what's offered in the NBA. Looking at different contract proposals, he'll consider the length of a contract (its maturity), the salary (the coupons or cash flow), and wages across the league (current interest rates).

Suppose the player is offered an average five-year contract at $1 million a year. He likes the cash flow, but he's nervous about the long-term commitment. If he takes the five-year contract and the average NBA salary spikes up, he'll be earning a lower salary than average in the last years of the deal, and a lower salary is more likely to become noncompetitive than a higher one. Duration expresses these trade-offs as a kind of risk measure that investors can use for comparison purposes.

One of the nonintuitive aspects of duration is that it's expressed in years, just like maturity. But duration isn't nearly as concrete a concept as maturity. Take a bond with a maturity of 11 years and a duration of 8.5 years. At the end of 11 years, we know that something happens—the bond is paid off. But what happens after 8.5 years? Nothing, really.

How useful duration is

Duration is a useful abstraction, though. The higher a bond's duration, the more it responds to changes in interest rates. If a bond fund has a duration of five years, you can expect it to gain 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. And that bond fund with a duration of 8.5 years? We know it's more volatile, and more vulnerable to interest-rate changes, than the bond fund with a duration of five years.

Some investors are fans of funds with short- and intermediate-term durations—between three and five years. They're just less volatile than longer-duration funds and offer nearly as much return.