Bonds, Duration and Interest-Rate Risk

A bond is a loan, but its market price can move

A bond is a debt security issued by a government, company, or other borrower. The investor lends money in exchange for promised interest and repayment terms. If a fixed-rate bond is held to maturity and the issuer meets its obligations, the contractual cash flows may be known. But before maturity, the bond can trade above or below its face value.

That market price matters to anyone who may sell before maturity and to funds that continuously hold portfolios of bonds. A bond fund does not have one maturity date at which the investor is guaranteed to receive a particular face value.

Why rates and fixed-rate bond prices usually move in opposite directions

Imagine an existing bond pays a fixed coupon based on a 3% market environment. If new comparable bonds become available at 5%, the old bond's fixed payments are less attractive. Its market price generally has to fall enough for a buyer to earn a return that is competitive with current alternatives. If market rates fall, the opposite effect can make the older higher-coupon bond more valuable.

This is interest-rate risk. It exists even when the issuer remains financially healthy. Credit risk is different: it is the risk that the issuer cannot make promised payments.

Duration measures sensitivity, not simply time to maturity

Duration is a measure related to the timing of a bond's cash flows and is commonly used to estimate how sensitive its price is to a change in yield. As a rough approximation, a bond or bond fund with a duration of five years might move about 5% in the opposite direction for a one-percentage-point parallel move in yields, before allowing for convexity and other effects.

This is an approximation, not a guarantee. Real yield curves do not always shift uniformly, and credit spreads can move at the same time. Duration remains useful because it translates an abstract rate move into an approximate price sensitivity.

Longer duration generally means more rate sensitivity

Longer-maturity fixed-rate bonds tend to have greater interest-rate sensitivity than otherwise similar shorter-maturity bonds because more of their value comes from cash flows further in the future. Lower coupons can also increase duration. Floating-rate instruments behave differently because their coupons can reset, though they still carry other risks.

A bond portfolio's duration can change over time as securities mature, new bonds are purchased, or the manager changes exposures.

Yield is not the same as guaranteed return

A quoted yield is based on price and expected cash flows under particular assumptions. Realised return can differ because the investor sells early, coupons are reinvested at different rates, the issuer defaults, a bond is called, or a fund changes holdings. High yield often reflects higher perceived risk rather than a free increase in return.

Compare yield with credit quality, duration, liquidity, currency exposure, call features, fees, and the reason the bond is in the portfolio.

Bond funds add portfolio mechanics

A bond fund owns many securities and may receive coupons, trade holdings, and distribute income. Its net asset value can rise or fall. Because the portfolio continually changes, "holding the fund to maturity" does not work the same way as holding one individual bond with a specific maturity date.

Funds can improve diversification across issuers, but they also introduce management fees and can still be concentrated by sector, country, credit quality, or duration.

Credit risk and spread risk

Corporate and other non-government bonds can trade at a yield spread over a lower-risk benchmark. If investors become more concerned about the issuer or sector, that spread can widen, pushing the bond price down even if benchmark interest rates do not change. A rate-risk model alone therefore cannot explain every bond-price movement.

Credit ratings are one input, not a guarantee. Investors should understand the issuer, seniority, security, covenants where relevant, and what happens in default.

Liquidity matters during stress

Some bonds trade less frequently than large public equities. In stressed markets, bid-ask spreads can widen and the price available for an immediate sale can be worse than a model value. Funds holding less-liquid assets can also face pressure when many investors redeem at once.

Liquidity risk is one reason a bond with a higher quoted yield may not be directly comparable with a more liquid security.

Authoritative references

Investor.gov: Bonds FAQ

Investor.gov: When interest rates go up, prices of fixed-rate bonds fall

Investor.gov: Bond funds and income funds