People move into bonds for safety and reach for the higher yield at the long end. But a 20-year bond can fall 25% or more when rates rise a couple of points — losses that look a lot like the share market they were trying to avoid. Duration is the number that tells you how much.
Price change uses the standard approximation — modified duration plus a convexity adjustment — which is accurate for moderate parallel shifts and understates the benefit of very large rate falls. "Break-even" is roughly the duration: hold longer than that and the higher reinvestment yield more than repays the price loss.
Equal amounts maturing every year. You always know what's arriving and when, and a rate rise stops being a loss — it becomes a better reinvestment.
Bonds are the "safe" part of most portfolios, which makes it a genuine surprise when they fall 25%.
When you buy a bond, you're locking in a fixed stream of payments. If interest rates then rise, newly-issued bonds pay more than yours does — so yours becomes less attractive, and its price falls until the maths works out even. Rates up, bond prices down. Always.
Duration is the number that tells you how much. It's measured in years, and the rule of thumb is beautifully simple: a bond with a duration of 7 falls about 7% when rates rise 1%. A duration of 17 falls about 17%.
This is why long-dated bonds aren't the safe option they appear to be. They pay a slightly higher yield, and in exchange they carry several times the interest-rate risk. In 2022, long government bonds — the most creditworthy securities in the world — fell further than many share markets.
Helen has $400,000 in bonds. Wanting a bit more income, she has a quarter of it in long-dated bonds yielding 4.9%, against 4.2% for short ones.
Her blended duration works out at 7.5. When rates rise a single percentage point, her bond holdings fall about $28,200.
Looking at it bucket by bucket: the short bonds fall about 1.9%. The long bonds fall about 15.2%. She picked up 0.7% of extra yield and took on roughly nine times the rate sensitivity to get it.
The fix isn't complicated. Shortening the long slice to match the rest would cost her a small amount of income and remove most of the risk — and for money that has to be there when she needs it, that's the better trade.
There's an elegant piece of maths here worth knowing. If you hold a bond portfolio for longer than its duration, a rate rise eventually helps you: the price falls, but every payment reinvests at the new higher rate, and by roughly the duration point you're ahead.
So compare your holding horizon to your duration. Horizon longer than duration means a rate rise is short-term pain and long-term gain. Horizon shorter means it's a real loss you won't have time to earn back — and that's a mismatch worth fixing.
A ladder means buying equal amounts maturing in each of the next several years. Held to maturity, you get your money back in full on schedule, regardless of what rates did in between — the price swings simply never touch you.
You give up a little yield and some flexibility. In return you get a known amount of money arriving in a known year, which for the portion of your savings earmarked for actual spending is usually exactly what you want.
General information only — not financial advice. Price changes are estimates from a duration-and-convexity approximation assuming a parallel shift in the yield curve; real curves twist rather than shift, and credit spreads move separately from government rates. Corporate and high-yield bonds carry default risk that duration says nothing about. Fund durations drift over time and should be checked against the fund's current published figure rather than assumed.