Definition
Duration is a measure of how much a bond's price will change when interest rates change, expressed in years and equal to the average time until the bond's cash flows are received.
Why it matters
Duration is the primary tool for understanding interest rate risk in fixed-income investments and in the general accounts that back most lifetime income products. It compresses the sensitivity of a bond, a portfolio, or an insurer's asset base into a single number that is directly comparable across different fixed-income structures.
How it works
Duration weights each of a bond's cash flows by the time at which it is received, then averages those weighted times. A bond that pays all of its cash flow at a single future date has a duration equal to that date; a bond that pays coupons throughout its life has a shorter duration than its maturity. The higher the duration, the more the bond's price moves when rates change: a bond with duration of five years falls by roughly five percent in price when interest rates rise by one percentage point, and rises by roughly five percent when rates fall by the same amount. This first-order relationship is exact only for infinitesimal rate changes; the curvature correction is measured separately as convexity.
In practice
For an individual holding a bond directly, duration is what tells you how much the value of the bond will move if rates change before you sell. For an individual evaluating a lifetime income product, duration is not visible in the quote but sits inside the general account that backs the product. Ask a professional what the duration of the insurer's asset portfolio is relative to the duration of the liabilities it supports, and whether the two are matched. A mismatch is what makes an insurer's balance sheet vulnerable when rates move quickly, which matters because the insurer's continued solvency is what makes an asset-backed lifetime income claim payable.
Related terms
- Convexity
- Yield curve
- Term structure of interest rates
- Present value
- Discount rate
- Asset-liability management
- Duration matching
- Interest rate cycle