Bond Duration

Duration combines a bond's maturity and its coupon payments into a single number. Strictly, Macaulay duration is the weighted average time until the bond's payments are received. Modified duration, derived from it, estimates the price change for a change in yield.

As a rule of thumb, if a bond has a modified duration of 7, its price will fall by about 7% if yields rise by one percentage point, and rise by about 7% if yields fall by one percentage point.

For example, a ten-year bond with a 5% coupon priced at face value has a modified duration of about 7.7. A two-year bond would have a duration of under 2, so its price would change much less.

Longer maturities and lower coupons mean higher duration and greater interest rate risk. Investors use duration to manage this risk. Someone expecting rates to rise might shorten the duration of their bond portfolio. Duration is an approximation that works best for small changes in yield; for larger changes, convexity is used to refine the estimate.