Overview
Duration measures a bond's price sensitivity to interest rate changes, expressed in years. It is the single most important risk metric in fixed income investing. A bond with a duration of 5 years will lose approximately 5% in value if interest rates rise by 1 percentage point.
Types of Duration
- Macaulay Duration: The weighted average time until all cash flows (coupons + principal) are received. Developed by Frederick Macaulay in 1938
- Modified Duration: Macaulay Duration adjusted for the bond's yield โ the most commonly used measure in practice
- Effective Duration: Accounts for bonds with embedded options (callable, putable, MBS). Essential for complex securities
- Key Rate Duration: Measures sensitivity to specific points on the yield curve (e.g., 2Y, 5Y, 10Y), not parallel shifts
Practical Applications
Portfolio managers use duration to control interest rate risk. 'Duration matching' โ aligning portfolio duration with a liability duration โ is fundamental to pension fund and insurance company management.
Why It Mattered in 2022-2023
The Fed's aggressive rate hikes devastated long-duration assets. The Bloomberg U.S. Aggregate Bond Index lost 13% in 2022 โ its worst year since inception in 1976. Silicon Valley Bank (SVB) collapsed in March 2023 partly because it held long-duration bonds (MBS with duration of 6+ years) that lost massive value as rates surged.
Key Rule of Thumb
Higher coupon = lower duration (you receive cash flows sooner). Zero-coupon bonds have duration equal to their maturity. Longer maturity = higher duration = more rate sensitivity.