Why is duration important for investing in bonds

Why does duration matter? If an investor owns an individual bond, then duration can express the gain or loss they may realize if they want to sell their bond prior to maturity and interest rates change. But if they may want or need to sell the bond before it matures, duration will help them understand how sensitive the price of their investment is to changes in interest rates.

In short, bonds that have shorter maturities and higher coupons tend to be less sensitive to interest rate changes, all other things being equal.

The concept of duration applies to bond funds mutual funds and exchange-traded funds , as well. Duration is quoted as the percentage change in price for each given percent change in interest rates. For example, the price of a bond with a duration of 2 would be expected to increase decline by about 2.

The duration of a bond is primarily affected by its coupon rate, yield, and remaining time to maturity. The duration of a bond will be higher the lower its coupon. Duration will be higher the lower its yield. Duration will also be higher the longer its maturity. These are hypothetical examples for illustrative purposes only. Credit quality is illustrated by ratings, which range from high to low, with triple-A being the highest and D being the lowest.

Lower-quality bonds usually sport large coupons to make the increased risk more attractive to investors. Since bonds make payments on a fixed schedule, inflation can factor in over time, eroding the value of the bond. Economic price increases, known as inflation, cause the value of the bonds to deteriorate. When a bond issuer enters default, they are unable to make period coupon payments or pay the principal of a bond.

Default risk is one of the risks a bond investor makes when purchasing a lower-rated bond. After all, you want to be sure the bond issuer can make timely payments—or any payments at all! Not that many investors paid attention to bond duration before the s because interest rates were relatively stable. In the s and s, however, interest rates started fluctuating dramatically, and people wanted a metric that would help them assess price volatility on their fixed-income investments, like bonds.

While bond investing is generally less risky than stock investing, factors like duration become important considerations if you decide to sell a bond before its maturity date.

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