by A.W. Berry

Created on: February 27, 2008   Last Updated: January 12, 2011

Bonds are specific types of loans to Government(s) be they foreign, federal or municipal, or Corporations. The interest for these loans can either be fixed i.e. unchanging or floating (changing) and is paid on specific time intervals. Bonds can also be convertible to other financial instruments, have the face value paid along with interest or not, and are exchanged in secondary markets such as the Chicago Board of Trade. Two important features of bonds are their maturity dates and duration. This article will discuss the difference between bond maturity and duration.

BOND MATURITY:

Bond maturity is fairly simple to understand in comparison to duration. Since bonds are like loans, at some point the principle of the loan has to be paid back. For example, if a bond had a 30 year life in which "coupons" i.e. the interest rate on the face value of the loan were paid, the face value of that bond could either be paid along with the coupons or bought back early as in the case with "call bonds". However, other bonds do not pay back the face value until the end of the established term of the loan. This end of bond life is known as "maturity" and is the point by which the face value of the bond must be paid back.

BOND DURATION:

Duration is an important financial equation that measures risk of return due to fluctuations in market interest rates. For example, since bonds are loans made from companies or governments to individuals or other companies or governments and new bonds are issued frequently, the benefits of older bonds may rise or decline in relation to new bonds. In other words, if interest rates rise on new bonds, the old bonds won't be as valuable in secondary exchanges because the new bonds are a better deal. The risk of this happening is termed interest rate risk and is measurable by the duration equation.

Duration is a very useful equation to investors because of its ability to quantify interest rate risk. This quantification assists in the investment decision making process and does so by expressing the relation between interest, time, and price variables of the bond. The result becomes an "interest rate sensitivity" i.e. risk level. Logically speaking, duration is a time value that either equals, is lower or greater than the original interest payments. In other words, when interest rates fluctuate old bond prices change, causing the duration value to also change. Since duration is a weighted average function of time, the greater the difference between original

• 1
• 2
• Next Page >>