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Bond duration describes the average time period before all the cash flows are received from a bond. Most importantly, it defines how the bond's price will change with increases or decreases in interest rates.
Beyond these points, here are three things you should know about bond duration before buying a bond or bond fund.
1. Finding a bond's duration
Luckily, brokerage firms and mutual fund companies publish bond duration information for individual bonds and funds in most brokerage accounts and on investor websites. So while it isn't necessarily important that you can calculate a bond's duration, it is important to understand what duration means.
Let's first consider a zero coupon bond. A rare type of bond, a zero coupon bond does not pay any coupons -- interest payments -- to investors. Instead, the bond is sold at a deep discount and the return is generated from redeeming the bond at face value at maturity. With no cash flows between time zero and maturity, a zero coupon bond's duration will always match its time to maturity.
Most bonds pay semiannual coupons to their owners, thus reducing the average duration of the expected cash flows. For example, the average bond in theVanguard Total Bond Market ETFhas an average effective maturity of 7.8 years, meaning principal will be repaid in an average of 7.8 years.
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However, because the bonds in this fund will make routine interest paymentsto the investor over their life, the average duration of all the cash flows (interest and principal)relative to the original price of the bond is 5.6 years -- 2.2 years less than the official time to maturity.
2. What bond duration tells you
Bond duration helps us use a simple rule of thumb to calculate what would happen to a bond or bond fund if interest rates moved up or down.
Using the Vanguard Total Bond Market ETF as an example, we can see that it has an average duration of 5.6 years. Thus, if interest rates jumped by 1%, then we would expect this bond fund to go down in value by about 5.6%. Likewise, if rates fell 1%, we would expect the Total Bond Market Index fund to rise in value by roughly 5.6%.
This is an imperfect measurement much like the well-known "rule of 72," but it approximates the effect of rising or falling interest rates well enough to use it to make investment decisions.
For example, bond duration would suggest that a 20 percentage point increase in market rates would result in a -130% decline in bonds with duration of 5.6 years. Obviously, we know this to be wrong -- no one in their right mind would pay you to take a bond off their hands. But for all practical purposes and interest rate changes -- say, no more than 5 percentage points -- bond duration is a useful measure of a bond's sensitivity to interest rate changes.
3. Using bond duration to limit your risks
You should always seek to match your expected holding period with a bond or bond fund's duration. Mismatches create the potential for big capital losses from swings in interest rates.
For example, long-term bond funds often have an average duration of 15 years or more. Thus, a 1 percentage point increase in market interest rates would result in a 15% decline in the fund's value -- a loss of nearly five years of interest payments at the time of writing. It would be a shame to hold a bond fund for five years only to break even when you redeem your investment.
Money that you intend to use in the short run should be kept in very low duration holdings to reduce your exposure to capital gains or losses from interest rates. Money that you can commit for the long haul can be used in longer-duration bonds and bond funds, to capture the higher interest payments that longer-dated bonds pay. Use bond duration as a guide and match your expected holding period with bonds of similar duration -- if rates rise, you'll be glad you did.
The article Bond Duration: 3 Things to Know Before Buying Bonds or Bond Funds originally appeared on Fool.com.
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