I’ve been talking to a lot of investors about how to prepare a portfolio for rising rates lately, and the same buzzwords keep popping up in these conversations. Two terms that often get confused are duration and maturity. Let’s take a look at their meanings and try to set the record straight.
When bond investors talk about duration it has a very specific meaning: The sensitivity of a bond’s price to changes in interest rates. The higher a bond’s duration, the more the bond’s price will change when interest rates move, thus the higher the interest rate risk. When investors believe interest rates are going to increase, they generally shift to a lower duration strategy to reduce the interest rate risk in their portfolios. It’s a phenomenon that we’ve seen time and again when the Fed hints at a rate hike.
Calculating duration rather involved, taking into account yields, bond coupons and that final maturity payment. The calculation essentially measures how sensitive the value of future cash flows are to changes in interest rates. As time passes duration for a bond generally declines.
A Closer Look at Maturity
Maturity refers to the date when a bond’s principal is repaid with interest. For example, a 10-year bond will mature in 10 years; the holder will receive the principal at that time. Investors also commonly refer to time to maturity which measures the amount of time between now and when a bond matures. The maturity date for a bond is usually set at issue and doesn’t change. But the time to maturity for a bond gets shorter over the bond’s life as you move closer to that maturity date.