Bonds and Interest Rates

The other key risk that bond investors face besides credit risk relates to interest rates. Bond prices move in the opposite direction of interest rates. When rates fall, bond prices rise. When rates rise, bond prices fall. Why? Remember that most bonds' interest payments are fixed, but prevailing market interest rates may change. If investors are able to buy a similar bond at a higher interest rate next month, then the market value of the lower-interest bond will decrease (that is, it will need to sell at a discount to its face value in order to attract buyers). When prevailing rates fall, then you could sell a higher-interest bond at a premium to face value.

Here is where duration comes in

To determine how dramatic a bond fund's ups and downs might be in a changing-rate environment, check out its duration. Duration measures a fund's sensitivity to interest rates, factoring in when interest payments are made as well as the final payment. 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 roughly 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. (The manager may be able to offset some of that price depreciation by buying higher-yielding securities, however.) 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.