What is duration risk in bonds?

Duration is the most important measure of interest rate risk in fixed income investing. In its most common form (modified duration), it approximates the percentage change in a bond's price for a 1 percentage point (100 basis point) change in yield. A bond with modified duration of 7 will decline approximately 7% in price if its yield increases by 1 percentage point, and appreciate approximately 7% if yield decreases by the same amount.

Several factors determine a bond's duration. Maturity is the primary driver: longer-maturity bonds have higher duration because their cash flows are received further in the future, making them more sensitive to discount rate changes. A 30-year Treasury bond has approximately 20 years of duration, while a 2-year Treasury has roughly 1.9 years. Coupon rate inversely affects duration: zero-coupon bonds have the highest duration for their maturity (duration equals maturity for zeros), while high-coupon bonds have lower duration because more of their value comes from near-term coupon payments. Yield level also matters: duration rises when yields fall because the present value of distant cash flows becomes more significant.

The 2022-2023 bond market selloff demonstrated duration risk vividly. When the Federal Reserve raised rates from near zero to over 5%, the Bloomberg US Aggregate Bond Index declined approximately 13% in 2022, its worst year in modern history. Long-duration Treasury bonds fell 30-40%. Silicon Valley Bank famously failed because it held a portfolio of long-duration mortgage-backed securities and Treasuries that lost billions in value as rates rose, while its deposit base proved unstable.

For portfolio construction, duration is the primary tool for managing interest rate exposure. Investors who expect rates to fall extend duration to benefit from price appreciation; those expecting rate increases shorten duration to reduce losses. Dollar duration (modified duration multiplied by market value) quantifies the absolute dollar gain or loss per basis point of yield change, enabling precise hedging. Understanding duration is essential for any investor holding bonds, bond funds, or rate-sensitive equities like utilities and REITs.