Bond duration explained: how to measure interest rate sensitivity
Bond duration is the key measure of interest rate risk in fixed income investing. It quantifies how sensitive a bond's price is to a change in interest rates: a bond with a duration of seven years will lose approximately 7% of its market value if interest rates rise by one percentage point, and gain approximately 7% if rates fall by one percentage point. Duration is both a risk measure and a time measure, and understanding both interpretations clarifies why it matters for portfolio construction.
What duration is
Duration was first defined by Frederick Macaulay in 1938 as the weighted average time to receive a bond's cash flows, where the weights are the present values of each payment as a share of the bond's total price. Macaulay duration is expressed in years. A five-year bond with a 3% coupon has a Macaulay duration somewhat less than five years, because some of the bond's value is received in coupon payments before maturity—earlier than the five-year term suggests.
Modified duration extends Macaulay duration into a direct measure of price sensitivity. Modified duration = Macaulay duration / (1 + yield), and it answers the question: by what percentage will the bond's price change for a 1% change in yield? For most practical purposes, when investors talk about a bond's duration, they mean its modified duration—the price sensitivity measure.
Dollar duration (also called DV01 or basis point value) expresses the same sensitivity in cash terms: it is the dollar change in a bond's price for a one-basis-point (0.01%) change in yield. A bond with a market value of USD 1,000,000 and a modified duration of 7 has a dollar duration of approximately USD 700 per basis point—meaning every 0.01% change in yield changes the bond's value by USD 700.
How it works
Duration rises with maturity and falls with coupon rate. A zero-coupon bond—which makes no payments until maturity—has a Macaulay duration exactly equal to its maturity, because all its value is received at the single payment date. A coupon-paying bond has a lower duration than its maturity, because coupon payments return some value before the final maturity date. Higher coupon rates pull the weighted average time earlier and reduce duration further.
For a bond portfolio, duration is the weighted average of the individual bond durations, weighted by market value. A portfolio with USD 500,000 in a two-year bond (duration 1.9) and USD 500,000 in a ten-year bond (duration 8.5) has a portfolio duration of approximately 5.2 years. This additive property makes duration a practical tool for managing aggregate interest rate risk across a fixed income portfolio.
Convexity refines the duration approximation. Duration estimates the price change as a linear function of yield change, but the actual price-yield relationship is curved (convex). For small yield changes, the linear approximation is accurate. For large yield changes—100 basis points or more—convexity becomes important: it captures the fact that price gains from falling yields are larger than price losses from equivalent rising yields, making a convex bond more valuable than the duration approximation alone suggests.
What the evidence shows
Duration's usefulness as a risk management tool has been confirmed across numerous market environments. The 2022 fixed income drawdown illustrated duration risk on a large scale: long-duration government bond indexes (duration of 15–20 years) fell 25–30% as yields rose sharply, while short-duration bond indexes (duration of one to two years) fell less than 5%. The duration measure predicted these relative outcomes accurately, demonstrating its reliability as a cross-sectional risk indicator within fixed income.
Duration also matters for immunisation strategies—matching the duration of assets to the duration of liabilities. Pension funds and insurance companies use duration matching to ensure that changes in interest rates affect their assets and liabilities in equal and offsetting ways, insulating the surplus (assets minus liabilities) from rate movements.
Limitations and trade-offs
Duration measures sensitivity to parallel shifts in the yield curve—movements where yields at all maturities change by the same amount. In practice, the yield curve does not always shift in parallel. It can twist (short rates rise while long rates fall), steepen (long rates rise more than short rates), or flatten (short rates rise more than long rates). A portfolio with a target duration does not necessarily have its risk fully characterised by a single duration number if the portfolio is exposed to non-parallel yield curve movements.
Duration is also defined with respect to yield to maturity, which assumes a flat yield curve. For bonds with embedded options—callable bonds, mortgage-backed securities—effective duration must be used, which accounts for the likelihood that cash flows will change if rates move significantly. Standard modified duration overstates the interest rate sensitivity of callable bonds and other option-embedded structures.
Bond duration in pfolio
Duration is a primary consideration when selecting fixed income ETFs for a pfolio portfolio. Shorter-duration bond ETFs provide lower interest rate risk and are appropriate when rate sensitivity needs to be contained; longer-duration ETFs provide higher sensitivity and tend to perform well in environments of falling rates. Fixed income assets available in pfolio, including their duration characteristics, are listed in the Assets section. The overall interest rate exposure of a fixed income allocation is visible in pfolio Insights.
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