Bond Duration and Interest Rate Sensitivity

This section explains the concept of bond duration and how it relates to the sensitivity of a bond's price to changes in interest rates.

Understanding Bond Duration

• Bond duration is a measure of the length of time, in years, it takes for a bond's cash flows to repay the investor the price they paid for the bond.

• A higher duration indicates that a bond's price is more sensitive to changes in interest rates.

• Conversely, a lower duration means that a bond's price is less sensitive to interest rate changes.

Factors Affecting Bond Duration

• The term or maturity of a bond affects its duration. Shorter-term bonds have lower durations, while longer-term bonds have higher durations.

• The coupon rate of a bond also impacts its duration. Bonds with lower coupon rates have higher durations, while those with higher coupon rates have lower durations.

Example: Christine and Michael's Bonds

• Christine holds a bond with a 10-year maturity, 0.15% yield to maturity, 2.25% annual rate, $1000 par value, and quarterly coupon payments. Its duration is 9.1.

• Michael has a similar bond with a 30-year maturity, 0.35% yield to maturity, 4.25% annual rate, $1000 par value, and quarterly coupon payments. Its duration is 15.32.

Impact of Interest Rate Changes on Bond Prices

• When interest rates increase, Christine's bond will decrease in value due to its higher duration.

• Michael's bond will experience an even bigger decrease in value because it has a higher duration than Christine's.

• Conversely, if interest rates decrease, Michael's bond will gain more value compared to Christine's due to its higher duration.

Other Factors Affecting Bond Value

• Duration is just one factor that affects a bond's value.

• Inflation risk, default risk, and call risk are also important considerations for investors.

Conclusion: Understanding Bond Duration and Risk

This section concludes the discussion on bond duration and its relationship to interest rate sensitivity. It emphasizes that duration helps investors assess the risk they face from interest rate changes.

• Duration provides investors like Christine and Michael with an understanding of how much risk they face from changes in interest rates.

• In addition to duration, factors such as inflation risk, default risk, and call risk should also be considered when evaluating a bond's value.