What Is Bond Duration and How Does It Affect Your Portfolio?
When investing in bonds, an important consideration is how long the term of the bond will be. Generally, a longer-term bond comes with a higher interest rate than a shorter-term bond. This makes sense because, over time, you can get more money from holding a 10-year bond versus a 1-year bond. When evaluating new bonds to purchase, you should consider how these rates will affect your bond portfolio.
Duration is a way of expressing the weighted average term to maturity of all the bonds in your fixed-income portfolio. It shows how sensitive an individual bond’s price is to changes in interest rates. A longer-duration bond requires more time for the issuer to pay back its debt, so it will be more sensitive to interest rate fluctuations than a shorter-duration bond.
When interest rates rise, the price of longer-duration bonds falls more than the price of shorter-duration bonds. This is because investors who want to sell their longer-duration bonds can only get a lower price due to the higher prevailing interest rates.
Conversely, when interest rates fall, the price of longer-duration bonds rises more than the price of shorter-duration bonds. This is because investors who want to buy long-duration bonds can get a higher price due to the lower prevailing interest rates.
Duration is expressed in years, and it is important to know its value when making investment decisions.
How Does This Affect My Portfolio?
If you have a portfolio that is weighted heavily towards longer-term bonds, a rise in interest rates could lead to losses. Conversely, if you have a portfolio that is weighted towards shorter-term bonds, a rise in interest rates would have less of an impact.
It is important to remember that bond prices move in the opposite direction of interest rates. That means that if you are more heavily invested in longer-term bonds, your portfolio will be most affected by an increase in interest rates.
Why Should I Care About How Long the Term of My Bonds Are?
It is important for investors to consider their current bond holdings when deciding on future investments. A portfolio with a greater proportion of longer-duration bonds will typically lose more in value in response to an interest rate increase than a portfolio with mostly shorter-duration bonds.
As interest rates rise, so does bond duration, so it is important to choose your investments carefully. The higher the prevailing interest rates are when you purchase new bond offerings, the less likely you are to want to buy longer-duration bonds.
In contrast, when interest rates fall, the prices of longer-duration bonds will increase more than shorter-duration bonds. This makes now a good time to invest in longer-term bonds if you believe that interest rates will stay low or continue to fall.
The Bottom Line
Duration is a way of expressing the weighted average term to maturity of all the bonds in your fixed-income portfolio. A longer duration bond requires more time for the issuer to pay back its debt, so it will be more sensitive to interest rate fluctuations than a shorter-duration bond.
The greater the proportion of long-term bonds in your portfolio, the more it will be affected by interest rate changes. Bond prices move inversely to interest rates, so when interest rates rise, bond prices fall and vice versa.
When making investment decisions, it is important for investors to be aware of the duration of their current bond holdings as well as the prevailing interest rates. If you have a portfolio weighted towards longer-term bonds, you may want to reconsider your investment strategy in light of increasing interest rates.
On the other hand, if interest rates are low and you believe they will stay that way, now might be a good time to invest in longer-duration bonds.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.