Talk About Duration

Duration is a measurement of a bond's interest rate risk that considers a bond's maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond's value may be to interest rate changes.

Understanding duration


A bond's price moves in the opposite direction of its yield, as illustrated in the chart below. This inverse relationship between price and yield is crucial to understanding value in bonds. Another key is knowing how much a bond's price will move when interest rates change. To estimate how sensitive a particular bond's price is to interest rate movements, the bond market uses a measure known as duration. Expressed in years, duration is the weighted average of the present value of a bond's cash flows, which include a series of regular coupon payments followed by a much larger payment when the bond matures and the face value is repaid.

How investors use duration to gauge interest rate sensitivity


Generally, the higher a bond's duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa. If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a longer duration would be appealing because the bond's value would increase more than comparable bonds with shorter durations.

As the table to the right shows, the shorter a bond's duration, the less volatile it is likely to be. For example, a bond with a one-year duration would only lose 1% in value if rates were to rise by 1%. In contrast, a bond with a duration of 10 years would lose 10% if rates were to rise by that same 1%. Conversely, if rates fell by 1%, bonds with a longer duration would gain more, while those with a shorter duration would gain less.

How active managers use duration


While duration does have limitations, it can be an extremely useful tool for building bond portfolios and managing risk. As a portfolio manager's interest rate outlook changes, he or she can adjust the portfolio's average duration (by adjusting the holdings in the portfolio) to coincide with the forecast. In contrast, passive bond strategies that hew to an index, such as the Bloomberg Barclays U.S. Aggregate index, which is a proxy for the bond market in the U.S., are forced to assume the duration and subsequent interest rate risk of that index. In the case of the Bloomberg Barclays U.S. Aggregate, shown in the chart to the right, duration has increased materially in the last eight years – and may be slower to change than a bond strategy that is actively managed.

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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2017, PIMCO.