Question

What is meant by duration of a bond security and its significance to bond investor

Answer 1

Meaning of duration of bond security: Duration is approximate measure of a bond's price sensitivity to change in interest rate

Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

For eample: If a bond has a duration of 6 years, for example, its price will rise about 6% if its yield drops by a percentage point (100 basis points), and its price will fall by about 6% if its yield rises by that amount.

A bond's duration changes with time and as its price and yield change.

Yield means interest rate earned on the investment.

Signficanceof Duration of bond security to bond investor:

1.Duration is important to bond investors because it acts as a guide for how sensitive a bond (or bond portfolio) is to changes in interest rates.

2.For investors, the bond duration indicates how much the market price of a bond will change when its yield (i.e. its current rate of interest) changes. Specifically, when yields rise, a bond’s price will fall by an amount approximately equal to the change in the yield, multiplied by the duration of the bond.

For example, if the yield on a bond with a duration of five years rises by 100 basis points (e.g. from 3% per annum to 4% per annum) the price of the bond could be expected to fall by 5% (e.g. from $100,000 per bond to $95,000 per bond). It is important to remember that yields and prices move in opposite directions so as yields fall bond prices rise and vice versa.

3.For investors looking to benefit from a fall in interest rates, they will look to buy bonds with a long duration or, in other words, bonds with low coupons and long maturities.

4.On the other hand, investors wanting to avoid interest rate volatility need to find bonds that have low duration or short maturity and high coupons.

5.Investors compare different manged funds or market indices can also look at the portfolio's average duration which is the weighted avaerage timing of cashflows of all te bonds in the portfolio.

6.. Investors using managed funds to find funds with greater or lower sensitivity to interest rate changes and therefore they can assess the risk or volatility of the portfolio.

Conclusion: In the end we can say duration includes certain factors like time to maturity. For example there can be 2 bonds with same yield 5% and same cost 1000$ but maturity period can be different.   A bond that matures faster say, in one year – would repay its true cost faster than a bond that matures in 10 years and duration of bond security  is imporant to investor because it act as a guide how sensitive a bond is to changes in interest rates.