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A bond’s duration is a measure of how sensitive its price is to a given change in interest rates.
The concept of duration is very important for fixed income investors as it essentially measures how sensitive a bond’s price is to interest rate movements, usually stated as a number of years.
Bond prices are said to have an inverse relationship with interest rates. Therefore, if interest rates rise, bond prices are likely to fall and if interest rates fall, bond prices are more likely to rise.
Bond investors should be aware that there are two main risks that can affect a bond's investment value: credit risk (the risk that an issuer of bonds will default on its payment obligations) and interest rate risk (rate fluctuations). Controlling the duration of a fund is one way a fund managers can use to mitigate the impact of the latter.
If a bond has a longer duration, investors would receive the coupon payments for longer and have the principal amount invested returned at a later date and so the bond's price is more likely to fall following a rise in interest rates. Therefore, the price of a bond with a shorter duration will be less impacted by a rise or fall in interest rates than the price of a bond with a longer duration.
For a ‘zero coupon’ bond* with a duration of 20 years could experience a fall in capital value of 20% if interest rates rise by 1%. Another similar bond with a duration of just 2 years will only experience a drop in capital value of 2% for the same 1% rate rise.
*A bond that is issued at a deep discount to its face value but doesn’t pay interest.
To illustrate the possible impact of duration with changes in interest rates on bond prices, AXA Investment Managers have designed a simple tool to help visualise this important characteristic of a bond – or bond fund.
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Source: AXA Investment Managers, 31.08.2016. For illustrative purposes only. Whilst every care is taken, no representation or warranty (including liability towards third parties), express or implied, is made as to the accuracy, reliability or completeness of the information contained herein.
*Assumes this is a ‘zero coupon’ bond.
Please note that this is for illustrative purposes only and no investment decisions should be made based on the tool. It does not take into account any other market variables that may affect the value of a bond or bond fund, apart from interest rates and duration.