Why bond prices fall when rates rise: duration explained

A fixed-rate bond promises a schedule of payments that was set when the bond was issued. If new bonds begin paying more, buyers will take the older bond only at a lower price. Its price falls until the return available to a new buyer is competitive with what is available elsewhere. The bond’s promised payments have not changed; the alternatives have.

The size of that price move depends largely on how long the investor must wait to receive the money. A bond maturing in two years has relatively little below-market income left. A bond maturing in thirty years may have decades of it. Bond funds summarise this average wait with a measure called duration. Because a coupon-paying bond returns some cash before maturity, its duration is normally shorter than its stated time to maturity.

Duration also provides a rough guide to price sensitivity. A duration of two means that a one-percentage-point rise in yields would reduce the price by about 2%. At a duration of fifteen, the approximate fall would be 15%. Two products both described as bond funds can therefore react very differently to the same change in rates. The duration shown on a fund’s factsheet tells the reader how much interest-rate risk sits behind the label.