by Orlando Miami

Created on: January 03, 2007   Last Updated: April 13, 2007

Most investors in bonds are familar with the bonds' maturity. The maturity of a bonds is the point in time when you receive back your principal. It is easy to know the maturity of a bond because most bonds are quoted based upon their maturity (i.e. 5 year bond, 10 year bond, 30 year bond, etc.). However, the duration of the bond is really the key measure of the bond because the duration of a bond measures its sensitivity to changes in interest rates.

Bonds will always increase in value as interest rates fall and decrease in value as interest rates rise. In addition, a bond's price will always approach its face-value as it approaches its maturity date. To better understand these relationships consider the motivation for buying a bond. When an investor purchases a bond he/she receives a return in the form of an interest payment (or coupon payment) at the prevailing rate in the market at the time of the purchase. Because the investor used his/her money to buy the bond, the investor no longer has that money available to purchase anything else, such as a car or another bond. Now, if interest rates go up, the investor will be worse off because if he/she had kept his/her money and used it to buy a bond now, he/she would receive a higher rate of return in the form of a higher interest rate. Also, if the investor wanted to sell his/her bond in the marketplace, he/she would now have to offer it at a discounted price because the other bonds in the market are offering higher interest rates. This dynamic causes bond prices to fall as interest rates rise.

The reverse is also true. If interest rates fell after our investor purchased his/her bond then he/she would now be better off because if he/she had waited and bought the bond after rates fell his/her return would be less. Now if our investor wanted to sell his/her bond he/she could charge a premium for it because it is offering a rate of interest higher than that available in the market.

What does this have to do with duration? Well, the duration of a bond will impact how sensitive a bond's price is to changes in the interest rate. In other words, duration will allow you to know how much your bond's price will change in value for a given change in interest rates. In fact, the duration measures by what percent a bond's value will change for a 1% change in interest rates. In other words, if a bond has a duration of 3, this means that a 1% increase in interest rates will cause the price of the bond to decrease by 3%. Likewise,

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