Duration
Duration is a measure of a bond's price sensitivity to changes in interest rates, expressed in years; the higher the duration, the more a bond's price will change for a given shift in yields.
Duration serves a dual purpose in fixed income analysis. In its original formulation — Macaulay duration, developed by Frederick Macaulay in 1938 — it represents the weighted average time it takes to receive a bond's cash flows. A 10-year bond paying a 5% coupon has a Macaulay duration of roughly 8 years, meaning you effectively 'recover' your investment in about 8 years when accounting for all the intermediate coupon payments, not just the final principal repayment.
The more practically useful concept is modified duration, which directly estimates the percentage price change in a bond for a 1% (100 basis point) change in yield. If a bond has a modified duration of 7, its price will fall approximately 7% if yields rise by 1 percentage point, and rise approximately 7% if yields fall by 1 percentage point. This makes duration an indispensable risk management tool for portfolio managers.
Several factors influence a bond's duration. Longer time to maturity increases duration — all else equal, a 30-year bond is far more interest-rate sensitive than a 2-year note. Lower coupon rates also increase duration because a greater proportion of the bond's value comes from the distant principal repayment. Zero-coupon bonds have a duration equal to their maturity, making them the most interest-rate sensitive securities in the fixed income universe. Callable bonds have shorter effective duration because the issuer is likely to call the bond when rates fall, limiting the price appreciation.
The Federal Reserve's dramatic rate-hiking cycle of 2022–2023 — when the federal funds rate rose from near zero to over 5% — illustrated duration risk vividly. Long-duration Treasury bonds and bond ETFs lost 20–30% of their value, comparable to equity bear markets, because of their extended duration. The iShares 20+ Year Treasury Bond ETF (TLT) fell more than 50% from its 2020 peak to its 2023 trough, a sobering reminder that 'safe' bonds can carry significant price risk.
Portfolio managers use duration matching — aligning the duration of assets with the duration of liabilities — to immunize portfolios against interest rate risk. Pension funds and insurance companies routinely employ this strategy to ensure their bond portfolios rise in value as interest rates fall, offsetting the increase in the present value of their long-dated liabilities. Dollar duration (DV01), which measures the dollar change in a bond's price for a 1 basis point move in yield, is the most common risk metric used in institutional fixed income trading desks.