Duration: Understanding the relationship between bond prices and interest rates

There is a common perception among many investors that bonds represent the safer part of a balanced portfolio and are less risky than stocks. While bonds have historically been less volatile than stocks over the long term, they are not without risk.

The most common and most easily understood risk associated with bonds is credit risk. Credit risk refers to the possibility that the company or government entity that issued a bond will default and be unable to pay back investors' principal or make interest payments.

Bonds issued by the US government generally have low credit risk. However, Treasury bonds (as well as other types of fixed income investments) are sensitive to interest rate risk, which refers to the possibility that a rise in interest rates will cause the value of the bonds to decline. Bond prices and interest rates move in opposite directions, so when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value.

If rates rise and you sell your bond prior to its maturity date (the date on which your investment principal is scheduled to be returned to you), you could end up receiving less than what you paid for your bond. Similarly, if you own a bond fund or bond exchange-traded fund (ETF), its net asset value will decline if interest rates rise. The degree to which values will fluctuate depends on several factors, including the maturity date and coupon rate on the bond or the bonds held by the fund or ETF.

Using a bond's duration to gauge interest rate risk

While no one can predict the future direction of interest rates, examining the "duration" of each bond, bond fund, or bond ETF you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates. Investment professionals rely on duration because it rolls up several bond characteristics (such as maturity date, coupon payments, etc.) into a single number that gives a good indication of how sensitive a bond's price is to interest rate changes. For example, if rates were to rise 1%, a bond or bond fund with a 5-year average duration would likely lose approximately 5% of its value.

Duration is expressed in terms of years, but it is not the same thing as a bond's maturity date. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate. In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration. When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes.

Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.

The chart below shows how a bond with a 5% annual coupon that matures in 10 years (green bar) would have a longer duration and would fall more in price as interest rates rise than a bond with a 5% coupon that matures in 6 months (blue bar). Why is this so? Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do. Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier.

10-year bond vs. 6-month bond

Image: The chart shows how a bond with a 5% annual coupon that matures in 10 years (green bar) would have a longer duration and would fall more in price as interest rates rise than a bond with a 5% coupon that matures in six months (blue bar).

*A simultaneous change in interest rates across the bond yield curve. This hypothetical example is an approximation that ignores the impact of convexity; we assume the duration for the 6-month bonds and 10-year bonds in this example to be 0.38 and 8.87, respectively. Duration measures the percentage change in price with respect to a change in yield.

Source: FMRCo

Of course, duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration. Therefore, in our example above, if interest rates were to fall by 1%, the 10-year bond with a duration of just under 9 years would rise in value by approximately 9%. If rates were to fall 2%, the bond’s value would also rise by approximately twice as much (18%).

Using a bond's convexity to gauge interest rate risk

Keep in mind that while duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates. This is because the relationship between bond prices and bond yields is not linear but convex—it follows the line "Yield 2" in the diagram below.

Using the illustrative chart, you can see how when yields are low, a 1% increase in rates will lead to a larger change in a bond’s price than when beginning yields are high. This differential between the linear duration measure and the actual price change is a measure of convexity—shown in the diagram as the space between the blue line (Yield 1) and the red line (Yield 2).

Relationship between price and yield in a hypothetical bond

Image: Relationship between Price and Yield in a Hypothetical Bond.

For illustrative purposes only. Source: FMRCo

The impact of convexity is also more pronounced in long-duration bonds with small coupons—something known as "positive convexity," meaning it will act to reinforce or magnify the price volatility measure indicated by duration as discussed earlier.

Keep in mind that duration is just one consideration when assessing risks related to your fixed income portfolio. Credit risk, inflation risk, liquidity risk, and call risk are other relevant variables that should be part of your overall analysis and research when choosing your investments.

Viewing and using duration data on Fidelity.com

Log in to your Fidelity account to get specific bond data using the tools and features outlined below.

Managing the duration of your portfolio

Plot the duration of your fixed income holdings using Fidelity's Performance & Analysis experience to see at a glance the weighted average duration of your fixed income holdings at Fidelity. The duration of your fixed income investments is also plotted on a grid in comparison to the benchmark.

View duration in the Fixed Income Analysis tool to see the duration of your bonds, CDs, and bond funds. Also, model the hypothetical addition to your portfolio of new bonds to see how they might impact the duration of the overall portfolio.

Accessing the duration of an individual investment

Locate a bond fund's duration in the bond fund's online profile under Portfolio Data.

Locate a bond ETF's duration from either the Snapshot page or Key Statistics, where the duration of the specific ETF can be compared to the asset class median duration.

Locate a bond's duration under each bond's Bond Details page.

Compare the duration of two bonds. As you review potential bond investments, you can easily compare duration and other characteristics between two bonds using this tool.

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Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Duration is a measure of a security’s price sensitivity to changes in interest rates. Duration differs from maturity in that it considers a security’s interest payments in addition to the amount of time until the security reaches maturity, and also takes into account certain maturity shortening features (e.g., demand features, interest rate resets, and call options) when applicable. Securities with longer durations generally tend to be more sensitive to interest rate changes than securities with shorter durations. A fund with a longer average duration generally can be expected to be more sensitive to interest rate changes than a fund with a shorter average duration.

The Fixed Income Analysis tool is designed for educational purposes only, and you should not rely on it as the primary basis for your investment, financial, or tax planning decisions.

The Performance & Analysis experience is provided for educational purposes only and is not intended to provide legal, tax, investment, or insurance advice, nor should it be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by Fidelity or any third party. You are solely responsible for determining whether any investment, investment strategy, security, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. You should consult your legal or tax professional regarding your specific situation.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

A bond ladder, depending on the types and amount of securities within it, may not ensure adequate diversification of your investment portfolio. While diversification does not ensure a profit or guarantee against loss, a lack of diversification may result in heightened volatility of your portfolio value. You must perform your own evaluation as to whether a bond ladder and the securities held within it are consistent with your investment objectives, risk tolerance, and financial circumstances. To learn more about diversification and its effects on your portfolio, contact a representative.

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