Time Span
In the world of finance, understanding the relationship between bond duration, interest rates, and bond prices is crucial for any investor. This understanding can help manage risk and make informed decisions about portfolio strategy.
Bond Duration
Bond duration is a measure that indicates the sensitivity of a bond's price to changes in interest rates. The longer the duration, the higher the sensitivity, meaning that bonds with longer durations are more sensitive to interest rate changes.
Interest Rates and Bond Prices
The relationship between bond duration, interest rates, and bond prices is fundamentally inverse. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This inverse relationship means that as interest rates increase, the price of a bond decreases, and vice versa.
Modified Duration
Modified duration refines this concept by providing a direct estimate of the bond price's percentage change for a 1% change in yield (interest rate). This adjustment makes it more practical for measuring interest-rate risk. For example, a modified duration of 5 implies that a 1% increase in interest rates will lead to an approximately 5% decline in the bond's price.
Interest-Rate Risk
By understanding modified duration, investors can quantify the interest-rate risk of a bond, enabling them to manage exposure and compare sensitivity across bonds effectively. A higher modified duration indicates a larger change in price for any given change in interest rates.
Key Points
- Bond duration measures the sensitivity of a bond's price to interest rate changes.
- The relationship between bond duration, interest rates, and bond prices is fundamentally inverse.
- Modified duration estimates the percentage change in a bond's price for a 1% change in yield.
- A higher modified duration indicates a larger change in price for any given change in interest rates.
- In a zero-rate environment, raising rates is likely to be more disruptive than raising them from a higher starting point.
- Lower yield on a bond increases its duration.
- The duration generally increases with a bond's maturity.
- For zero-coupon bonds, duration is always the remaining time to maturity.
- For interest-paying bonds, duration is always less than maturity.
Investors can use the concept of modified duration to quantify the interest-rate risk of a bond by calculating the percentage change in a bond's price for a 1% change in yield. A higher modified duration indicates a larger change in price for any given change in interest rates, thus requiring careful management of exposure in personal-finance and investing. As interest rates rise, the price of bonds with longer durations decreases significantly more than those with shorter durations, making it essential for bond investors to comprehend these relationships in finance.
