Let us take bonds as our fixed-income investment to help you understand the concept of duration.
When we talk about duration, we are talking about the length of time it will take for the cash flows of the bond to pay back the investor. In simpler terms, the duration of a bond is an indicator of the effects that a change in interest rates will have at that particular bond. For instance if a bond has a duration of fifteen eight years, it determines that a change in interest rates will have a great impact on the price of that bond.
This can either be good or bad depending upon whether the interest rates have increased or decreased. If the rate of interest increases, the price of a bond with greater duration will fall greatly as compared to the one with a smaller duration. Similarly, if the interest rate decreases, the price of a bond with shorter duration will have a slight increase in price as compared to the one with greater duration – which will have a greater increase in price.
Put in simpler terms, an increase in interest rate decreases the price of the bond and vice versa. However, this increase or decrease depends vastly upon the duration of that bond. The greater the duration, the greater will be the change in the price.
A common example to understand duration and its effects is the five-year example. Consider yourself investing in a five-year fixed-investment. In this case, a one percent rise in the interest rates will trigger a five percent decrease in the price of the investment, whereas a one percent fall in interest rates will feature a five percent increase in the price of that investment.
The duration of a bond also depends upon its coupon rate. Just like the interest rate, the coupon rate also has an inverse relation with the duration of the investment. It means that a higher coupon rate will result in a shorter duration of the bond and vice versa.
Other factors affecting Duration
Apart from the interest and coupon rates, the duration of a fixed-payment investment also depends upon the following:
Other factors affecting price of the bond
The value of a bond also depends upon several factors other than duration and interest rates. These factors include:
Although there are many factors that determine the value of a fixed-income investment, the duration of a bond is one of the most vital factors that investors take into account while investing their money.
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