Another risk that bond investors face is interest rate risk--the risk that rising interest rates will make their fixed interest rate bonds less valuable. To illustrate this, let's suppose you bought a $1,000 par value bond with a 10-year maturity and a 6% coupon rate. You will earn 6% of $1,000, or $60, each year that you own the bond. Let's further assume that after one year, you decide to sell it, and at that time, new bonds are being issued with 7% coupons. Investors can choose between your 6% bond and a new 7% bond. To entice someone to buy your bond, you will to have to discount its price so that the new owner will earn the same $60, but will have paid less than $1,000 to buy it, thus raising his or her yield closer to 7%.
A bond's duration will determine how its price is affected by interest rate changes. The reverse is also true. Using the example above, let's assume that when you sell your bond, new bonds are being issued with 5% coupons. Investors can choose between your 6% bond and a new 5% bond. Comparatively, your bond is now much more attractive. An investor will be willing to pay more than $1,000 to earn 6% rather than 5%.
Duration is the tool that helps investors gauge these price fluctuations that are due to interest rate risk. Duration is expressed as a number of years from the purchase date. In simple terms, a bond's duration will determine how its price is affected by interest rate changes. In other words, if rates move up by one percentage point--for example, from 6% to 7%--the price of a bond with a duration of 5 years will move down by 5%, while a bond with a duration of 10 years will move down by about 10%. You will notice that all components of a bond are duration variables. That is, the bond's duration, coupon, and yield-to-maturity, as well as the extent of the change in interest rates, are all significant variables that ultimately determine how much a bond's price moves.
Duration Is a Guide to Selecting Bonds >>