What is bond duration in simple terms?

When it comes to bonds, the most commonly mentioned parameters are yield and maturity.

But investors have another important tool to help them assess a security's risk and sensitivity to interest rate changes: duration.

At first glance, the term sounds complicated and is more suitable for academic finance textbooks.

However, when you think about it, duration is simply a way to measure how quickly an investor will get their money back and how the bond's price will change if market rates rise or fall.

Definition of duration

Duration is the weighted average return period for funds invested in a bond, taking into account all future payments (coupon payments and par value redemptions). Simply put, this number indicates how many years it will take an investor, on average, to get their investment back.

For example, if a bond without coupons (a so-called discount bond) matures in 3 years, its duration is 3. If the security has regular coupon payments, the investor receives part of the money earlier, and the duration will be less than the term to maturity—say, 2.4 years.

How to calculate bond duration

At first glance, the duration formula looks cumbersome, but if you explain it step by step, everything becomes clear.

The formula looks like this:

$$D = \frac{\sum (CF_t \times t / (1+r)^t)}{\sum (CF_t / (1+r)^t)}$$

Where:

• CF_t — cash flow at time t (coupon or par value redemption),

• t — year (or period) number,

• r is the discount rate (current market yield of the bond),

• D —duration in years.

Simply put, we take all future payments on the bond, “weight” them over time and convert them to today’s value, and then divide them by the bond’s price.

Step-by-step example

Let's imagine a bond with 1,000 , a term of 3 years, and a coupon of 10% per annum . This means that the investor receives:

• at the end of the 1st year: 100,

• at the end of the 2nd year: 100,

• at the end of the 3rd year: 100 + 1000 (return of the nominal value).

If the discount rate is the same as the coupon (10%), then the bond price = 1000. Now we calculate the duration:

1. We multiply each payment by the time it is received:

   • 100 × 1 = 100

   • 100 × 2 = 200

   • 1100 × 3 = 3300

2. We bring it to today's value (divide by (1+0.1)^t):

   • 100 / 1,1 ≈ 90,9

   • 200 / 1,1² ≈ 165,3

   • 3300 / 1,1³ ≈ 2478,9

3. We add and divide by the price of the bond (1000):

   $$D ≈ (90.9 + 165.3 + 2478.9) / 1000 = 2.73 years$$

That is, the duration of this bond is approximately 2.7 years , which is less than its maturity date (3 years), since part of the money is returned earlier through coupons.

What is the purpose of bond duration?

1. Rate change risk assessment.

The primary use of duration is to measure how much a bond's price will change as market interest rates change. A simple rule applies: the higher the duration, the more sensitive the security is to changes in yield.

2. Comparison of different bonds.

Duration helps compare securities with different maturities and coupon payments. This is especially important if an investor is building a bond portfolio and wants to understand its sensitivity to interest rates.

3. Portfolio management.

Institutional investors (funds, banks) use duration to balance assets and liabilities. For example, if a bank has five-year liabilities, it tries to select assets with similar durations to reduce risk.

A simple rule to remember

You can think of duration as a "sensitivity pendulum":

• A 2-year duration means that if rates rise by 1%, the bond's price will fall by about 2%.
• Duration of 7 years - a drop of about 7% with the same change in rates.

This is not an exact formula, but a simplified rule, but it helps a lot in everyday life.

Why does a private investor need this?

Many novice investors think the most important thing is to choose a bond with a good yield. But experienced investors always look at duration, which indicates how risky it is to hold a bond given possible economic changes.

If you expect rates to rise, it's better to buy securities with a short duration. If rates, on the contrary, fall, a long duration will allow you to earn more on the price increase.

Bond duration isn't a complicated formula for financiers, but a handy tool that helps you understand exactly when your money will be returned and how much the price will change as interest rates fluctuate.

For investors, this means: the higher the duration, the greater the risk and potential return; the lower the duration, the more stable the investment. Understanding this metric makes bond investments more informed and helps avoid unpleasant surprises.