Duration Risk is a key key term when it comes to discussing bonds. When investing in bonds, there are several important considerations: the bond’s coupon rate, the current (and future) interest rate, and time to maturity. The interaction of these three variabels determine the bond’s value, and the amount of risk involved with holding the bond at a given time. Duration is measure that takes all three into account, and allows investors to compare risk between bonds of differing maturities and coupon rates.

Q. We’re suddenly hearing this term thrown around a lot, especially because of the Fed’s determination to keep rates low. What’s it mean?
A. Let’s start with “duration”. This is a term that describes how long it will take for a bond investor to get his investment back. Obviously, if the bond has a big coupon, like 10%, it will take less time to get his principal back than if the bond has a coupon like 2% (today’s T bond rate). The lower the coupon, the longer the “duration”.

Q. OK, now how about the “risk” part of the term?
A. Of course, as interest rates rise, bond prices fall. But they don’t fall by the exact same amount, % wise. Other factors being equal, bonds with longer maturities will fall relatively more than shorter duration bonds. Bonds with lower coupon bonds will fall relatively more than higher coupon bonds. Both of those facts stem from the bond’s duration.

Q. So: the longer the duration of a bond, the longer its going to take an investor to get paid back, the more sensitive it’s price is to rising interest rates.
A. Exactly! And that’s what people mean by “duration risk”. And its important now because there’s so much very long term, very low coupon paper out there. That combo means extremely long duration, and therefore huge price risks if interest rates rise. Just a couple interest rate point move will have a huge impact on the prices of those long term, low interest rate bonds

Q. So, duration risk might actually be even more important than credit risk…
A. Yes, especially, of course for treasuries. Individual investors really need to appreciate that…. It seems you’re investing in a “safe” security, but there are very big price risks, whether you hold directly or through bond funds.

Q. And I guess the hedge fund world is all over this.
A. Absolutely, hedge funds understand all this very well, which is why you’ve seen a big spike in them going short the 10 year. The downside of the Fed’s ZIRP is that it creates a lot of duration risk in the market.