Bond duration - Wikipedia
Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest. Duration measures how long, in years, it takes for the price of a bond to be and a bond's price remain constant, we'll see an inverse relationship between the. Consider a bond investment's duration to understand the potential impact of interest rate fluctuations.
In general, six things affect a bond's duration: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration. The lower the coupon, the longer the duration and volatility.
Zero-coupon bonds, which have only one cash flowhave durations equal to their maturities. The longer a bond's maturity, the greater its duration and volatility. Duration changes every time a bond makes a coupon payment.
Over time, it shortens as the bond nears maturity.
Duration: Understanding the Relationship Between Bond Prices and Interest Rates - Fidelity
The higher a bond's yield to maturity, the shorter its duration because the present value of the distant cash flows which have the heaviest weighting become overshadowed by the value of the nearer payments. The presence of a sinking fund lowers a bond's duration because the extra cash flows in the early years are greater than those of a bond without a sinking fund.
Bonds with call provisions also have shorter durations because the principal is repaid earlier than a similar non-callable bond.Macaulay Duration
Understanding the duration formula is not nearly as important as understanding that duration is a measure of risk because it has a direct relationship with price volatility. Bonds with higher coupon rates have lower convexity, while zero coupon bonds have the highest convexity.
The price yield graph of a straight bond always have a positive convexity. The slope of the tangent to the graph will increase when yield decreases.
This means that the duration of such a bond will increase as yield decreases.
On the other hand, callable bonds can have negative convexity for a part of the price yield graph. This means that for some yield values, the duration of these bonds increases as yield increases.
Bond Price, Yield and Duration
There is a certain point on the curve beyond which it will not make sense for the company to call the bonds as it would be more expensive to raise fresh money from the market. Beyond this point, the curve will behave just like a noncallable bond.
Before this point, there is a strong possibility that the bond issuer will choose to call the bond, as the company can raise fresh money from the market at a cheaper interest rate. Conclusion Making investments in bonds can be a lucrative financial opportunity for those who put in the effort to understand how this market functions. There are many complicated and simple concepts that are used to assess the value of a bond and the state of the market.
Although some of these concepts will be difficult to understand initially, as you start investing in bonds and analyze different bonds more carefully, you will realize how useful this understanding can be. Besides getting a good grasp of these concepts, you should also make sure that you stay updated with any major news about the issuer.
After all, the biggest risk to your investment is that the issuer will default on its payments.