Bond duration, in the broadest sense, is the amount of time that must pass before a bond issue reaches maturity. Within this process, close attention is paid to the actual worth of the bond as it moves toward maturity. Calculating the value duration of a bond is relatively simple when the rate of interest applied is fixed, although determining the current value of a variable rate bond at a specific point in the maturation process is not particularly difficult.
A more in-depth concept of bond duration at it relates to all types of bonds is as a means of measuring the degree of sensitivity that the bond issue exhibits to interest rate movements. Bond duration is normally measured in years, with careful attention given to the actual value of the bond at each annual interval. In the case of fixed rate bond issues, the interest accrued is easily identified by consulting the terms and conditions of the bond issue itself. With a bond that carries a variable rate, it is necessary to identify the prevailing rate of interest at the point in which the current interest payment is due. This change in the value of the bond due to the application of the interest rate is known as the dollar duration.
There are a number of different formulas in use for identifying the bond duration. One of the more common approaches is known as the Macaulay duration. Developed by Frederick Macauley, this approach identified the weighted average maturity associated with the bond issue, assuming that the weights are the discounted cash flows that apply to the current interest period of the bond. The idea behind Macauley’s approach was to make it much easier to determine the level of risk associated with a given bond issue, based on the variable rate of interest, or even the possibility of the bond being called early.
Investors who prefer the relatively low risk level associated with bond issues can further insulate themselves from possibly failing to earn as much of a return as they would like by taking the time to project the bond duration. This is especially true in situations where the bond is structured in a manner that allows the issuer to call the bond early. By taking into account the possible fluctuations in interest rates, and how that fluctuation could impact the bond from the time of issue to the point of maturity, the investor is in a much better position to determine if purchasing the bond is actually worth the time and effort.
