Bond Duration

We already know that the (Present) Value of any investment is the sum total of all future financial
benefits, each discounted at a rate
commensurate with the perceived C o n v e x ity o f B o n d C u r v e
risk. We kn ow, too, t hat as the
receipt of a cash benefit is pushed $ 1 ,1 0 0 .0 0
farther and f arther into the future,
the present value of that benefit
diminishes. Bonds are no exception. $ 1 ,0 0 0 .0 0

Therefore the risk of recovering the $ 9 0 0 .0 0

full reversionary value of the bond Market Value

increases wit h the tim e to maturity .

But in t he interi m, a percent of the $ 8 0 0 .0 0
purchase price may be rec overed as
a function of the coup on rate of the $ 7 0 0 .0 0
bond. A bo nd with a hig her coupon
rate – say 10 %, or $100 p er y ear -
will return a higher percentage of $ 6 0 0 .0 0
the bond’ s current market value
over a given number of y ears when
$ 5 0 0 .0 0
compared to a bond o f sim ilar 6 .0 % 7 .0 % 8 .0 % 9 .0 % 1 0 .0 %
maturity but with a lower coupon Y i e ld T o M a t u r it y
rate, say 7% per year.

The calculation of Bond Duration brings all these factors together in one number, allowing us to
have a measurement of a bond’s price sensitivity to changes in market interest rates.

Derivation of Macaulay's Duration Factor

We can represent the present value, or current market price, of the bond as:
n
CFt
Value = ∑
t =1 (1 + i ) t
where CF = coupon payment per period t
i = current market yield rate per period of time (annual rate/2)
t = time (expressed in 6-month periods)
n = number of 6-month periods to maturity
If we seek t o measure the sensitivity of the Valu e (V) of the b ond in response to changes in
market yield rates (i), we need only take the first differentiation of V with respect to i :
n Note that Dur ation
- t * CFt
∑
dV always ca rries a
di = (1 + i) t +1
negative sign because
t =1 of the sign of t. Since
t is expressed in
years, Dur ation is
When the value of i is small, as it will be when changes in m arket y ield also e xpressed in
1 years. But Duration is
rates a re s mall, the expression substantially equa tes to 1. To not a pay back period,
(1 + i) nor does it repr esent
1 time to maturity.
simplify the matter then, let’s m ove one factor outside the
(1 + i )
summation portion of the formula, leaving:
n –t * CFt
dV
∑
1
= (1+i)
di (1+i)t
t =1

Then, since it substantially equates to 1, we can temporarily ignore it:

n –t * CFt n –t * CFt
∑ ∑
dV
di = 1 * (1+i)t
=
(1+i)t
t =1 t =1

CFt
But the expression represents the Present Value of the particular cashflow CFt.
(1+i)t
n

∑
dV
Therefore we can restate the equation as approximately di = –t * (PV)CFt
t =1

In 1938, Frederick R. Macaulay defined Duration as the total weighted average time for recovery
of the payments and principal in relation to the current market price of the bond. Bond Duration,
therefore, is
n
- t * (PV)CF t
Duration = ∑t =1
Market Price

n
where Market Price = ∑ t=1
CF t
(1 + i ) t

and (PV)CFt = the Present Value of cashflow t.

How Bond Duration is Calculated
The calculation of a bond’ s Duration was a time-consuming task in Macaulay’ s day. Today the
computer makes the measurement of bond value as a result in a change in m arket yield - o r any
other variable - a relatively minor chore. Yet, bond Duration is still a valuable strategic tool in the
hands of the bond investor, especially in assembling a portfolio of bonds.

Following Frederick Macaulay’s formula, Bond Duration for a 3-year bond, bearing a 6% coupon
and a market yield of 10%, is calculated as:

A B C D E F G
1 Year1 Pmt # Coupon $ PV Factor $PV PV/Price Duration2
2 -0.50 1.00 $30.00 0.952381 $28.57 0.0318 -0.0159
3 -1.00 2.00 $30.00 0.907029 $27.21 0.0303 -0.0303
4 -1.50 3.00 $30.00 0.863838 $25.92 0.0288 -0.0433
5 -2.00 4.00 $30.00 0.822702 $24.68 0.0275 -0.0549
6 -2.50 5.00 $30.00 0.783526 $23.51 0.0262 -0.0654
7 -3.00 6.00 $1030.00 0.746215 $768.60 0.8554 -2.5663
Market
8 $898.49 3 1.0000 –2.7761
Value =

Therefore this bond, with a current value of $898.48, has a Duration of –2.7761.
The steps in calculating the Duration as it appears above are:
1. Determine the coupon rate. The coupon rate/2 * $1000 = PMT (Coupon $).
2. Determine the PV factor using the yield per period: 1/(1+ i)t where t is the PMT # and i
is the annual interest rate/2
3. Multiply the PV Factor (d2) * Coupon$ (c2) to get the $PV (E2) of the Coupon
payment.
4. Add the $PVs of the cashflows in column (E) to determine Market Value of the bond
(E8)
5. Divide each result of step #3 ($PV) by the current market value (E8) of the bond.
6. Multiply this factor (F2) by the years (A2) in column 1.
The sum of all final values in the right-hand column is the Duration.
Remember that Duration always carries a negative sign.

1
The time in years is negative to conform to Macaulay's formula.
2
Bond Duration is the product of PV/Price * the value under column Year. This is the reason that
Duration is expressed in terms of years, but this is obviously not the capital pay-back period.
3
The Market Price is the summation of all the separate PVs in the cashflow.
Determinants of Duration
As we can see fro m the eq uations above, coupon ra te (which determ ines the size of the periodic
cashflow), yield (which deter mines present value of the periodic cashflow), and time-to- maturity
(which weights each cashflow) all contribute to the Duration factor.

Holding coupon rate and maturity constant –

Increases in market yield rates cause a decrease in the present value factors of each
cashflow. Since Duration is a product of the present value of each cashflow and time,
higher yield rates also lower Duration. Therefore Duration varies inversely with yield
rates.
Holding yield rate and maturity constant –
Increases in coupon rates raise the present value of each periodic cashflow and therefore
the market price. This higher market price lowers Duration. Therefore Duration varies
inversely to coupon rate.

Holding yield rate and coupon rate constant –

An increase in maturity increases Duration and cause the bond to be more sensitive to
changes in market yields. Decreases in maturity decrease Duration and render the bond
less sensitive to changes in market yield. Therefore Duration varies directly with time-to-
maturity (t).

Using Duration and Modified Duration

The magnitude of the Du ration is an i ndex to the sensitivit y of the bond to changes in market
interest rates. Bonds with high Duration factors experience greater increases in value when rates
decline, and greater losses in value when rates increase, compared to bonds with lower Duration.

In order to more closely approximate the percent change in market value as the result of a percent
change in yield, Macaulay derived Modified Duration, which is simply Duration times the factor
which we removed when we derived the formula for Duration above.
1
Modified Duration (DM) = Duration *
(1+i)
In the example above, where Duration is −2.7761, the Modified Duration is:
MDuration (DM) = – 2.7761 * 1 = –2.6439
(1 + 0.10 )
2
Note that the value of i (0.10) is the annual yield rate which must be divided by 2.
Macaulay used this Modified Duration, D M, to approximate the percent change in bond value for
a given percent change in yield, using the following formula:

Percent change in bond value = DM * change in yield.

If y ield rates rose fro m 10% to 10.5% , a 0.5% increase in rat es, Macaulay ’s for mula would
predict a percent change in value as:

Percent change in bond value = DM * numerical change in stated yield.4

= – 2.6439 * (+ 0.5)
= – 1.3220%

The price ch ange calculated by MDura tion would b e $898.49 * –1.32 2% = –$11.88 The new
bond price would be approximately $898.49 – $11.88 = $886.61. We can confirm the percent
change and new price by entering these data into a spreadsheet: The change takes place in the
PV Factor as a result of the change in market yield.

Year Pmt # Coupon PV Factor $PV $PV/ Price Duration

-0.50 1 $30.00 0.95012 $28.5036 0.03215 -0.01608
-1.00 2 $30.00 0.90273 $27.0818 0.03054 0.03054
-1.50 3 $30.00 0.85770 $25.7309 0.02902 -0.04353
-2.00 4 $30.00 0.81491 $24.4474 0.02757 -0.05514
-2.50 5 $30.00 0.77426 $23.2279 0.02620 -0.06550
-3.00 6 $1030.00 0.73564 $757.7128 0.85453 -2.5636
Price $886.70 1.00000 -2.77438

As y ou can see, the computer indicates a dec line in value fro m $898.49 to $ 886.70, a loss of
$11.79 vs. $11.88 as predicted by Macaulay’s approximation using Modified Duration.

This difference in the answer we have obtained is caused by th e convexity of the bond value
curve. Macaulay’s formula describes a straight lin e, but bond value in response to yield changes
describes a convex curve. When y ield changes are small (as in th is example), the difference in
value change is negligible, but when these differe nces are substantial (larger percent changes in
market yield and higher Duration) then the differences in value increase.

If the Duration of our exam ple bond were in the order -8 or -12, an increase of 1.0 % in interest
rates would i ndicate a loss of appro ximately 8% ( $71.88) an d 12% ($10 7.82), respectively in
bond price. But because of these large changes in yield, and the high Duration, the linearity of the
Duration curve would result in larger pricing erro rs. Therefore the use of Duration to estimate
change results is a reason able approximation, especially when the changes in interest rates are
not too large.

Significance and Use of Duration

In the pre-c omputer days of Macaulay , Duration was concei ved as a short-hand m ethod of
estimating price volatility as the result of changes in market yield. Today, the value of Duration is
somewhat less evident, since co mputer pricing programs are widely available which can indicate

4
Since Modified Duration is a negative value, a decrease in yield rate results in an increase in bond
value. Multiplying the negative Duration times a decrease in yield results in an increase in bond value.
precisely the value of a bond with respect to all the important financial variables: coupon, yield
and time. Still, Duration can be used by the bond investor to implement his investment strategy.

If the investor believes that market yields are going to decline, he may wish to alter his bond mix
to include bo nds carrying higher Durations in orde r to leverage the increase in bond value. If an
increase in yields is expected, he may elect to change the mix to include bonds of lower Duration
to minimize the negative effect on his portfolio..

Obviously bonds are subject to risk be yond changes in the coup on-yield-maturity variables, e.g.
the risk of default, but Duration is not intended to reflect risk; it measures interest rate sensitivity.

Duration and the Bond Portfolio

Perhaps the most prevalent use of Du ration toda y is as a short-hand m ethod of estim ating the
potential changes in the value of a portfolio of bonds.

Assume that a portfoli o c onsists - for simplicity’s sake - of t hree bonds carr ying the foll owing
current prices and Modified Durations:

Bond Current Price Mod. Duration

A $845.57 4.12257
B $625.95 7.3523
C $884.17 4.04855

On a given day the market yield increases 20 basis points (+ 0.2%). What effect will this have
on the value of this portfolio? Fortunately, the HP–12C has a set of statistical re gisters which will
calculate a weighted mean. Here are the keystrokes (set decimal to f 5 ):

Key In Display Shows Comments

-4.12257 Enter -4.12257 Enters Mod. Duration
0.2 % −0.00825 Mod. Duration x % change
845.57 ∑ + (4,9) 1.00000 Puts price into statistical register
−7.3523 Enter −7.3523 (same as above)
0.2 % −0.01470
$625.95 ∑ + 2.00000
−4.04855 Enter −4.04855
0.2 % −0.00810
$884.17 ∑ + 3.00000

Now, by recalling R2 (3,8), you will retrieve the total of all the original bond prices:
 RCL 2 2,355.69 Total of original prices.
RCL 6 −23.3354 The loss in value.
(This is a loss since
the rate increased).
+ 2,332.3546 Adds the loss to show the
new value of the portfolio.
f 2 $2,332.35 Re-sets price to 2 decimal places.

This article has been excerpted from:

Introduction to Cashflow Analysis., Robert J. Donohue CCIM, Regent School Press,
ISBN 978-1-886654-09-9

Visit the webpage at www.regentschoolpress.com. [email protected]

All rights are reserves. No portion of this text may be reproduced by any means without
the express permission of the publisher, Regent School Press.