The "Understanding Duration"
tip sheet in the BondWorks Learning Center
on the Tools page comprehensively explains how
interest rate changes affect bond prices. This tip sheet includes several
charts that graphically illustrate duration and its affects. Below is
a condensed version of information contained in the tip sheet.
A fixed income investment consists of a series of cash flows an investor receives over the life of a bond. These cash flows can be in one of the following forms:
Coupons (periodic interest payments)
Periodic return of principal (available with some mortgage backed or structured asset bonds)
Return of principal at final maturity or an earlier call date.
The size, timing and frequency of these cash flow payments influence all bond calculations, including duration which can be described as “the average time it takes to get your money back."
Duration values change as market values change and time passes. The practical duration measures below define the boundaries of potential price movement (volatility) for possible price/yield values on any given date. Each applies to an approximate 1% change (100 basis points) in the yield calculation specified.
Modified Duration to the Earliest Call—Yield change calculated to the earliest call date; the most conservative and least price movement given a 1% change in interest rates.
Modified Duration to Worst—Yield change calculated to the priced to worst date; generally used to reflect the behavioral characteristics of a bond as of a specific price/yield and date; consistent with industry calculations, always calculated to the priced to worst date, including all call features.
Modified Duration to Maturity—Yield change calculated to final maturity date. This reflects the most aggressive and greatest price movement given a 1% change in interest rates.
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