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Bond Duration: What It Is and Why It Matters

The maturity of a fixed-income investment is simply how long the instrument lasts. For example, a 10-year Treasury bond has a 10-year maturity.

Duration is a slightly more complicated concept, but it’s very useful for understanding how bonds and other fixed-income investments work.

The duration of a bond is the weighted-average period of time before the cash flows involved are received. (Technical note for those curious: The weight for each period is not based on the nominal value of the cash flow received at that time, but rather the present value of the cash flow.)

How About Some Examples?

A CD that has a 5-year maturity has a 5-year duration as well, because the only cash flow involved — the payment received when the CD matures — will be received in five years.

In contrast, a 5-year Treasury bond will have a duration that’s less than its 5-year maturity. If sold for face value, a 5-year Treasury bond with a 1% coupon rate will have a duration of 4.89 years. The reason the duration is less than 5 years is that some of the cash flows (specifically, the interest payments) will be received prior to the bond’s 5-year maturity.

A 5-year corporate bond with a higher yield will have an even shorter duration. For example, if sold for face value, a 5-year bond with a 5% coupon rate would have a duration of 4.49 years. Despite having the same maturity as the lower-yielding Treasury bond, it has a shorter duration. The reason for this is that a larger portion of the bond’s overall value is received prior to maturity (because, due to the higher yield, the interest makes up a greater portion of the total cash flows).

Conclusions: The shorter the maturity of a bond, and the higher its yield, the shorter its duration.

Why Bond Duration Matters

For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. Specifically, when interest rates rise, a bond’s price will fall by an amount approximately equal to the change in the applicable interest rate, times the duration of the bond.

For example, if a 10-year Treasury bond has a duration of 9 years, and interest rates for 10-year Treasuries increase by 1%, the bond’s price will fall by ~9%. (Conversely, if 10-year Treasury bond interest rates fell by 1%, the bond’s price would increase by approximately 9%.)

The same goes for bond funds: The average duration of the fund tells you how sensitive the fund will be to changes in market interest rates.

For example, Vanguard’s Extended Duration Treasury ETF holds nothing but Treasury bonds, but with an average duration of 27 years, it’s extremely high-risk. When interest rates crashed in 2008, the fund put up a positive 55% return. Then in 2009 when rates came back up, it had a negative annual return of almost 37%.

In contrast, Vanguard’s Short-Term Investment Grade fund (with an average duration of 2.2 years) is much lower-risk, despite the fact that that the credit quality of its bonds is meaningfully lower. In the last 15 years, the fund has only had a negative return once. And that loss was a not-exactly-catastrophic 4.74%.

Conclusion: When considering a bond fund, to get an idea of the risk level involved, you need to check not only the credit quality of underlying bonds, but also their average duration.

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Comments

  1. Mike,

    Somewhat off-topic, but since you’re talking about bonds, would you do an article some day about municipals? They’re not part of Vgd’s TBM, but Vgd offers them for some states. I am wondering whom they would most benefit and what the tax ramifications are. Let’s say, for example, that as an NY resident I’d want to buy Vgd’s NY bond fund because it is tax-exempt in NY. But if I did so (highly unlikely), should they be held in a tax-deferred or taxable account? Or should one buy municipals from other states as well?

  2. Hi Larry.

    Thank you for the article suggestion.

    Just to give some brief answers…

    In general, I think muni bonds make sense once:
    1) You’ve filled your entire tax-sheltered space with bonds, yet
    2) You still need more bonds to satisfy your desired bond allocation, and
    3) You’re in a high enough tax bracket that the after-tax yield on taxable bonds of similar credit quality is lower than the yield on muni bonds.

    As you mentioned, the reason the state-specific funds exist is to take advantage of the exemption from state income taxes as well as federal income taxes. (Muni bonds are generally only exempt from federal income tax, but bonds issued by municipalities in that state will be exempt from state income tax as well.)

    So, if you have a high state income tax rate, there’s a significant tax advantage to sticking with muni bonds from your own state. The flip side of the argument, of course, is that you’d be sacrificing some degree of diversification. (I’ve never done any research into how significant a sacrifice that is. As an off-the-cuff answer, I’d think it depends to a large degree on what overall portion of your bond holdings would be in the fund in question.)

  3. Thanks, Mike. I think you’re not only sacrificing diversification, but exposing yourself to increased credit risk if your state defaults or its bond rating takes a hit. (Probably that was implied in your answer.) But if a federal or state tax-exempt bond fund is held in a tax-sheltered account, does it retain that tax status on withdrawal, or are all withdrawals from an IRA taxed as ordinary income?

  4. “an IRA” = a tax-deferred, not a Roth.

  5. Assuming that no after-tax contributions were made, anything (including interest from muni bonds) coming out of a tax-deferred account will be taxable as ordinary income. So holding muni bonds anywhere other than a taxable account is generally not a good idea.

  6. You mention that when interest rates go up, the bond fund will take a hit. But won’t the fund eventually rise up to (or higher?) than its original price once the higher interest payments from the underlyings start to come in? How long does that take?

  7. Hi, NJ.

    Yes, the bond will regain its original value. And, yes, the fact that market interest rates are higher will help that to happen faster (because interest payments can be reinvested at the new, higher rates).

    In fact, the duration of the bond is the length of time that it will take to break even. You could think of the duration as the “indifference point” to changes in interest rates.

  8. Mike, I can understand an “indifference point” if one needs a known amount of money at a known time in the future. But most of us hope that our investments will at least match if not noticeably beat inflation, and there tends to be a positive correlation over the long-term between interest and inflation.

    Could you really buy a 10-yr duration bond or bond fund now at prevailing low interest rates, and be indifferent after holding 10-years as to whether interest rates stayed low or soared to 10+%? I suspect not.

  9. Mike,

    Congratulations on the recognition from Rick Ferri and at Bogleheads!

    This is a great explanation, especially for low-maintenance investors. My head started hurting when learning that the duration of a bond can exceed its maturity date due to various embedded options and what not.

  10. Duration is an extemely important concept for investing in and determining the risk of bonds. Thanks for reminding us. I think investors and bloggers have put less emphasis on duration because of the current low yield (making duration closer to bond maturity). When interest rates rise the concept becomes more and more important in accessing the risk.

  11. I guess that there is no quick way to estimate duration? So it probably not particularly useful to most DIY investors, as a number? An important concept, however.

    My own trick, to keep things simple, is to only buy bonds that are hovering around par – then I have a pretty good idea how they compare with other income-producing investments.

  12. Moneyman,

    There’s no need to estimate it at all. With a bond fund, you can simply look it up. With an individual bond, you can calculate it in just a few seconds using any of several online calculators, like this one: http://www.investopedia.com/calculator/BondDurCDate.aspx#axzz1cvcan600

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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