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.