THE EFFECT OF CHANGING INTEREST RATES ON BOND VALUES

Another risk that bond investors face is interest rate risk -- the risk that rising interest rates will make their fixed interest rate bonds less valuable.  To illustrate this, let's suppose you bought a $1,000 par value bond with a 10-year maturity and a 6 percent coupon rate.  You will earn 6 percent of $1,000, or $60, each year that you own the bond.  Let's further assume that after one year, you decide to sell it, and at that time, new bonds are being issued with 7 percent coupons.  Investors can choose between your 6 percent bond and a new 7 percent bond.  To entice someone to buy your bond, you will to have to discount its price so that the new owner will earn the same $60, but will have paid less than $1,000 to buy it, thus raising his or her yield closer to 7 percent.

The reverse is also true.  Using the example above, let's assume that when you sell your bond, new bonds are being issued with 5 percent coupons.  Investors can choose between your 6 percent bond and a new 5 percent bond.  Comparatively, your bond is now much more attractive.  An investor will be willing to pay more than $1,000 to earn 6 percent rather than 5 percent.

Duration is the tool that helps investors gauge these price fluctuations that are due to interest rate risk.  As previously discussed, duration is expressed as a number of years from the purchase date.  In simple terms, a bond's duration will determine how its price is affected by interest rate changes.  In other words, if rates move up by one percentage point -- for example, from 6 percent to 7 percent -- the price of a bond with a duration of 5 years will move down by 5 percent, while a bond with a duration of 10 years will move down by about 10 percent.  You will notice that all components of a bond are duration variables.  That is, the bond's duration, coupon, and yield-to-maturity, as well as the extent of the change in interest rates, are all significant variables that ultimately determine how much a bond's price moves.

As you can see, duration is a powerful tool for any bond investor looking to make the most of his or her buying, selling, and holding decisions.  Let's recap what we have learned.