The Oxford English Dictionary says that duration is the period of time during which an event continues to happen; or the length of time that something lasts. In finance, duration is probably the most significant and yet the most misunderstood term. In the investment world it has a very specific meaning, which often gets lost in translation.
Duration is mostly associated with the underlying arithmetic of bond prices. It refers to the sensitivity of bond prices to changes in interest rates – or to put it another way; the weighted average time to maturity of all remaining principal and coupon (interest) payments.
Investors who purchase bonds undertake two primary exposures – default risk and interest-rate risk. The risk of default is that the underwriter of the bond reneges on the repayment at maturity. The interest-rate risk is how exposed investors are (+/-) to changes in interest rates – if interest rates move then the value of the investment changes.
Duration is calculated by reference to the current value of the bond, the bond yield, the bond coupon, the final maturity date and liquidity features. In essence, (although it is a bit more complicated):-
Duration = Present value of the cash flows; multiplied by the length of time to receipt of the cash flows; divided by the bond’s current value.
The resulting answer in euro terms is then divided by 100 to express the number in years, or part thereof.
Duration is always expressed as a number in years; longer-term bonds have more duration. The universal rough rule of thumb in bond mathematics states that if interest rates rise by x%, the price of bonds will fall by (duration times x%). So, for example, if the duration of a 20-year bond is 15 and interest rates rise by 1.00%; then the bond will lose c15% in value.
Knowing the duration of a selection of bonds is vital because it allows investors to compare their suitability more accurately even if they all have a variety of coupon payments and maturity dates. It, therefore, allows investors to compare the degree of risk being undertaken and how sensitive bond prices are to changes in interest rates. In simple terms, the lower the duration the less sensitive the bond is to interest rates movements.
Unsurprisingly, consumers often confuse duration with maturity. Maturity is the length of time until the principal is returned to the investor, e.g. a 10-year bond will earn interest for 10 years and then it will mature. Duration is not the same thing.
It is important to note that duration is not a perfect measurement for all varieties of bonds. The calculations work best for Government bonds, which closely track actual wholesale market prices. Calculations for other types of bonds are less accurate. As with all market jargon inexperienced investors should be wary. While the lingo has a clear meaning for professionals it is often used to dupe unsuspecting consumers. After all, bonds are complex instruments that require candid consideration.