What Is Duration Risk?
You buy a bond because you want a return from it. But what happens if interest rates suddenly change?
The value of your bond can change even though you haven’t sold it.
The reason is duration.
Duration is a way of measuring how much a bond’s price is likely to change when interest rates move.
Think about two bonds.
One has a duration of 2 years and another has a duration of 8 years.
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If interest rates go up, both bond prices will generally fall, but the 8-year duration bond will usually fall more.
For example, if a bond has a duration of 8, a 1% increase in interest rates would mean its price could fall by roughly 8%.
If rates fall by 1%, its price could rise by roughly 8%.
These are estimates, not exact numbers, but they help explain the relationship.
This is what we mean by duration risk — the risk that changes in interest rates affect the value of a bond.
It is especially important for investors holding longer-term bonds because they tend to have higher duration and therefore greater sensitivity to interest-rate movements.
So when interest rates are changing, looking at the bond’s duration helps investors understand how much its price could move.
