Interest rate risk is the sensitivity of a bond’s value to variability of market interest rates/yields. In general, as interest rates increase, bond prices decrease (and vice versa). A bond’s duration is the number of years it takes for a bond to pay out its original cost by its internal cash flows and is the common measure of a bond’s interest rate risk. A bond’s duration is also interpreted as how the bond price is affected by interest rate changes. For example, we expect that the price of a bond with duration of 5 years to fall 5% if the market interest rate increases by 1%, and to rise 5% if the interest rate decreases by 1%. A higher duration indicates a higher interest rate risk of a bond. Note that the duration of a zero-coupon bond is always equal to its time to maturity.
Duration = – percentage change in bond price / percentage change in yield
The factors affecting duration are:
- Maturity. If two bonds are identical except for maturity, the one with shorter maturity has the lower duration as the bond which matures sooner would repay its original cost more quickly.
- Coupon rate. If two bonds are identical except for coupon rate, the bond with lower coupon has higher duration as it will pay back its original cost slower than the higher coupon bond.
- Call feature. If two bonds are identical except for the embedded call option feature, the bond with call option has lower duration than the option-free bond. It limits the upward movement of the bond price when interest rate decreases as the bond price will not rise above the call price.
- Put feature. If two bonds are identical expect for the embedded put option feature, the bond with put option has lower duration than the option-free bond. It limits the downward movement of the bond price when interest rate increases as the bond price will not fall below the put price.