Longer duration implies higher interest rate risk

Duration of a bond indicates the extent to which its price will move in response to interest rate changes. Duration is expressed in number of years and is shorter than the term of the bond. In general, the longer the duration of a bond, the more sensitive it is to interest rate changes. In other words, duration can also be used as a measure of interest rate risk. A longer-term bond typically has a longer duration.

Risks vary with different interest rates

Duration is also the weighted average of the present value of the cash flows. Its calculation takes into account the fixed coupon payment during a bond’s life and the face value paid at the maturity date. Duration can be used as a measure to compare the interest rate risks of bonds with different maturities, face values and coupon rates. When faced with the same decline in interest rate, the price of a bond with a longer duration will be more volatile than one with a shorter duration.

Investors with higher risk tolerance may consider bonds with a longer duration if they perceive that the interest rate is trending down. Conversely, when the interest rate goes up, bond prices will go down. Investors holding bonds with longer duration may suffer a greater loss due to the more severe drop in prices.