Duration in Bonds: Meaning, Types, Formula And Example

Key Takeaways 
 

• Duration in bonds gives ideas to investors about their bond price after the modified duration.
   
• This is normally used by callable bonds and mortgage-backed securities, pension funds, and insurance companies.
   
• Higher modified duration means interest rate is also high and less modified duration means interest is low. 

Bonus tip - Many Indian debt mutual funds disclose a duration range (e.g., 2–5 years) and actively adjust it based on interest-rate expectations.

Duration in bond is a measurement of price of bond after reviewing fluctuations in interest rate. In short, duration in bond is inversely proportional to the change in interest rate. When the interest rate goes up the bond price goes down and vice versa. It shows the sensitivity of your bond to the interest rate change.  

How to Use duration in bond 

Investors use duration in bonds to know the price of their bonds after the change in interest rate. When bond duration is more than the interest rate changes and bond price changes drastically. When bond duration is less the change in bond price is also less. This helps investors to know about the risk. 

Investors analyse interest rate, they take the gauge of interest rate, that how much it can raise or fall. And according to that they choose bond duration. If the interest rate is going up they choose short duration because it will give them a higher price. If the interest rate is going to fall they choose a long duration, because the price will increase. 

Next, investors use these bonds for portfolio management. This is a very important and useful tool by which investors manage their bond portfolio and risk. Portfolio managers can do some changes and adjustments in the average duration of the portfolio to be aligned with the future. If portfolio managers estimate that the interest rate will go up they lengthen the average duration of the portfolio in order to gain more benefits and vice versa. 

The main aim of duration in bonds is to give estimation of changes in price of bonds by analysing interest rate and investors do use this for the same purpose. 

Example:

Priya is a CA working in MNC. She bought a corporate bond for 10 years with a 7 year modified (changing) duration. The value of bond is Rs. 1000. The Reserve Bank of India increased the interest rate by 1%. Because of that the bond price falls by 7%. 

7-years * 1% = 7%

The price of the bond becomes Rs. 930. 

Highlights of the duration in bond 

The main reason to introduce this bond was to know the price of the bond after changes in interest rate. With duration you can analyse your coupon rate, payment structure, and cash flow in average time. In maturity you are able to know only about final payment but in duration you get all the information related to the interest and price change. 

Pension funds and  insurance companies use duration in immunizing their portfolios. Pension funds have to give money to retirees. They invest money in bonds for exactly the same time when they have to pay their retirees. In this case, even if the interest rate changes, the bond price and interest payment will help. In the same way insurance companies invest in bonds because they also have to pay claims to their policyholders.

There are some types of duration in bond

Macaulay Duration

 In Macaulay duration, investors get to know about their interest payment and the final payment they are going to get. 

Modified Duration 

Modified duration is simply a bond sensitivity to the interest rate. When the interest rate changes the price of a bond also changes. If interest rate increases the bond value decreases and if interest rate decreases the bond value increases. 

Effective Duration

This is specifically useful for those bonds who have special features like call or prepayment. Some bonds can be repaid before the duration. It shows how much bond price and interest rate will change. 

History and Background of duration in bond 

Duration in bond was introduced by the Canadian economist Frederick Macaulay in 1938. In the name of Macaulay this is also known as Macaulay Duration. It became popular in the 1970s because of interest rate volatility.