"Maturity" and "duration" may sound somewhat alike, but mean very different things.
What is maturity?
Maturity is pretty straightforward. A bond's maturity is the length of time until the principal must be paid back. So a 10-year bond will earn interest for 10 years from the date it is purchased. At the end of that time period the bond's principal is repaid to the owner of the bond and interest payments cease.
Let's say we bought a 10-year bond at a face value of Rs 1,000 and a 5% coupon rate (annual fixed interest rate). If we hold the bond for 10 years, we will receive yearly payments of Rs 50 (5% of 1,000), and then at the end of the holding period, we will get back the Rs 1,000 principal value of the bond.
What is duration?
A bond's duration is a more abstract concept often used to measure interest-rate sensitivity. Bond investors often pay attention to interest-rate movements because any movement up or down in rates has the opposite effect for bond prices. That's because an increase in interest rates makes an existing bond (and its now below-market interest rate) worth less while a drop in rates increases the bond's value.
Like a bond's maturity, a bond's duration is expressed in years. But unlike maturity, which is the length of time until a bond's interest payments cease and its principal is paid back (in the case of our hypothetical bond, 10 years), the duration number also incorporates yield, coupon, maturity, and call features.
It goes deeper…
- Macaulay duration: Named after Frederick Macaulay, who developed it in 1938, it provides a weighted average of the time to receipt of future cash flows (interest (coupon) and principal ). Broadly, is it the number of years required to recover the true cost of a bond, taking into account the present value of all coupon and principal payments received in the future. Due to these payouts (in other words, because you're recouping some of the cost of the bond before maturity), the duration of an interest-paying bond will always be shorter than its maturity. The higher the interest rate, the shorter the duration--this makes sense because the later cash flows would carry lower significance in present value terms, due to discounting at higher rates.
- Modified duration: This is a measure of sensitivity of bond prices to changes in interest rates.
- Effective duration: This measure is used to assess interest-rate sensitivity when option-embedded securities (say callable bonds - those that may be paid off before maturity) are involved.
- Average effective duration: This is an asset-weighted measure of the effective duration of securities held in a fund and is particularly useful as a guide to how interest-rate movements will affect the overall portfolio as a whole.
Bond prices have an inverse relationship with interest rates.
Let's go back to our earlier example (10-year bond, Rs 1,000 par value, 5% coupon). Let's say we decide to sell this bond. But new 10-year bonds are being issued with 8% coupons. Why would someone want to buy our bond, which pays Rs 50 per year, when she could buy one for the same price that pays Rs 80 per year? To entice someone to buy our bond with its lower yield, we'll have to mark the price down to less than Rs 1,000, thus raising the buyer's yield closer to 8%.
But the reverse is true in a falling-interest-rate scenario. If new 10-year bonds are being issued with a 3% yield, our 5% coupon bond looks a lot more attractive. A prospective buyer might be willing to pay more than Rs 1,000 to own our 5% bond.
Duration is a tool that helps investors anticipate and understand price fluctuations that are due to interest-rate movements.
Investors can use duration to help estimate how a bond or bond fund's value would be affected by a change in interest rates. For example, a bond with a duration of 5 years would be expected to rise 5% in value for every 1-percentage-point decline in interest rates (remember that interest rates and bond prices move in opposite directions). If interest rates go up by one percentage point, the bond's value would be expected to drop 5%. This measure allows investors to gauge interest-rate sensitivity for bonds with different maturity dates and interest (coupon) rates. For example, a bond with a duration of 6 years would normally be twice as sensitive to interest-rate changes as one with a duration of 3 years regardless of when they mature or what they pay in interest.
Bonds with longer durations are more sensitive to interest-rate changes than those with shorter durations.
So investors who expect interest rates to decline might look for bonds or bond funds with longer durations or maturities to increase potential exposure to falling rates, whereas investors expecting rates to go up would prefer shorter durations or maturities to limit exposure to the higher rates. Longer-duration bonds and bond funds also typically have higher yields than their shorter-term counterparts to compensate investors for taking on added interest-rate risk.
Duration is just an estimate. It can provide guidance, not certainty.
Though two bond funds have the same average effective duration, they could still react differently to interest-rate changes if their underlying securities are different. To elaborate further, note that portfolio duration is just an average. The duration of a fund portfolio consists of the weighted average of the durations of its underlying bonds. So the gain or loss predicted by duration will be most accurate if market yields change the same amount at every point along the yield curve. Such a situation is rare, though. In fact, it's possible for some rates to rise while others fall (a yield-curve twist). In that scenario, two different funds with the same average duration could perform differently.
Maturity and duration are not the only considerations when investing in bond funds. Credit quality, issuer concentration, portfolio liquidity, past performance including analyzing any drawdowns and past downgrades/upgrades, and expense ratio are other factors.