Investors new to fixed income are often surprised that a bond can lose value. The coupon is fixed and the principal is repaid at maturity, so where does the loss come from? The answer is that a bond's price is what someone else will pay for it today, and that depends on what alternative returns are available.
The mechanism
If you hold a bond paying a fixed coupon and prevailing interest rates rise, newly issued bonds offer more income than yours. Yours becomes less attractive, so its market price falls until its yield is competitive with the new issues. Rates fall, and the reverse happens.
What duration measures
Duration expresses a bond's sensitivity to that effect, approximately: the percentage change in price for a one percentage point change in yield. A bond with a duration of five will fall roughly five percent in price if yields rise by one point. Longer-dated bonds and lower-coupon bonds have higher duration, and therefore more price volatility.
Why it matters to you
If you intend to hold to maturity and the issuer does not default, interim price movements do not affect what you ultimately receive. If you may need to sell before maturity, duration tells you how much price risk you are carrying. Matching the duration of a portfolio to the horizon over which the money is needed is the single most useful discipline in fixed income investing.
This note explains a general concept and is not a recommendation regarding any particular security.
Important information
Investing in securities involves risk, including the possible loss of principal. The value of investments and the income from them can fall as well as rise, and past performance is not a reliable indicator of future results. Research published on this site is provided for information only and does not constitute investment advice or a recommendation to buy or sell any security. Consider your objectives and financial circumstances, and seek independent advice where appropriate.