Duration
Also written Bond duration
A measure of how sensitive a bond's price is to changes in interest rates — the higher the duration, the larger the price swing for a given change in rates.
In plain language
Bond prices move when interest rates move — and they move in the opposite direction. When rates rise, bond prices fall; when rates fall, bond prices rise.
But not every bond moves by the same amount. Duration measures how much a particular bond's price will swing for a given change in interest rates. A higher duration means a bigger swing, in either direction.
How it works
The workbook frames duration inside its discussion of interest rate risk: bond prices and interest rates have an inverse relationship — rates up, prices down, and vice versa. The extent of that interest rate risk in any given bond depends on its duration, which is calculated based on the coupon, term to maturity and yield applicable to the bond.
The rule of thumb the workbook draws out: the higher the duration, the greater the interest rate risk in the bond, and vice versa. This risk extends to debt mutual funds too, since a fund holding longer-duration bonds will see its NAV move more sharply with rate changes than a fund holding shorter-duration paper.
A worked example
A retiree holds two debt funds: one invests in bonds with an average duration of 2 years, the other in bonds with an average duration of 8 years. Interest rates in the market rise by 1 percentage point.
The short-duration fund's NAV falls only modestly, since its lower duration means less price sensitivity to the rate move. The long-duration fund's NAV falls considerably more for the same 1-point rate rise, precisely because its longer duration means greater interest rate risk. A retiree drawing near-term income from the long-duration fund at that moment would be forced to redeem units at a depressed NAV — exactly why a bucket strategy keeps near-term spending money out of longer-duration debt.
Why NISM asks about it
Chapter 2, section 2.6 (Common Risks in Investments), introduces duration under "Interest Rate Risk" as the measure that determines how much a bond is exposed to that risk. Expect a question linking higher duration to higher interest rate risk, and to apply that link when comparing two debt funds or bonds.
Common exam traps
- Higher duration means more price sensitivity to rate changes — in both directions. A long-duration bond gains more when rates fall, not only loses more when rates rise.
- Duration is driven by coupon, term to maturity and yield together — term to maturity alone is not the same thing as duration, though the two move in the same general direction.
- The duration effect extends to debt mutual funds holding those bonds, not just to individual bonds held directly — a common gap in exam answers that treat duration as relevant only to direct bond holdings.
Check yourself
1.An investor needs to park money for three months before paying a house down payment. Which asset class is appropriate and why?
- a)Equity, because a long horizon allows appreciation
- b)Cash and equivalents, because these have little or no volatility in returns and the funds can be used when required without any risk of loss to the principal
- c)Long duration debt funds, because they offer the highest yield among debt options
- d)Gold, because it acts as a hedge against inflation
Show the answer
Answer: (b) Cash and equivalents, because these have little or no volatility in returns and the funds can be used when required without any risk of loss to the principal
For very short periods the workbook prescribes cash and equivalents to park their money, because these investments have little or no volatility in returns, and investors will be able to use the funds when required without any risk of loss to the principal.
The objective here is preserving the absolute value of the capital invested and high liquidity, rather than earning returns. Low return is the design, not a defect.
Equity needs a long horizon to benefit from economic cycles. Long duration debt carries the greatest interest rate risk — a rate rise three months before the payment would be costly. Gold gives no periodic income and its price could fall over three months.
The governing principle: as goals come closer and the investment horizon shrinks, investors should shift funds from the volatile asset class to one with steady returns.
2.Interest rates fall sharply. How does this affect a bank deposit holder compared with a holder of listed bonds?
- a)Both suffer equally, since both earn only interest income
- b)The deposit holder is stuck with low interest income, while the bondholder gets low coupon PLUS capital gains as bond prices rise
- c)The bondholder suffers a capital loss while the deposit holder is protected
- d)Neither is affected, since both are debt instruments with fixed returns
Show the answer
Answer: (b) The deposit holder is stuck with low interest income, while the bondholder gets low coupon PLUS capital gains as bond prices rise
The workbook contrasts them directly.
Deposits: ⚠️ "Debt investments such as DEPOSITS EARN ONLY INTEREST INCOME. THERE IS NO CONTRIBUTION FROM CAPITAL GAINS to the total returns. IN PERIODS OF LOW INTEREST RATES, DEPOSIT HOLDERS HAVE TO MANAGE WITH THE LOW INTEREST INCOME, WHICH IN SOME CASES MAY NOT EVEN BE ADEQUATE TO BEAT INFLATION."
Bonds: ⚠️ "IN PERIODS OF LOW INTEREST RATE, THE COUPON INCOME MAY BE LOW, BUT THE LOW INTEREST RATES PUSHES UP THE PRICES OF BONDS IN THE MARKETS. THE TOTAL RETURN GOES UP DESPITE THE LOW INTEREST INCOME BECAUSE OF THE CONTRIBUTION FROM CAPITAL GAINS."
Same asset class, opposite experience — because one instrument has a market price and the other does not.
⚠️ The symmetric warning: this comes with the risk of capital loss eating into interest income earned IF SECURITY VALUES WERE TO DECLINE IN A RISING INTEREST RATE SCENARIO, and the extent of change in value will depend upon THE DURATION of the bond: higher the duration, higher will be the gain or loss.
Option (c) reverses the price-yield relationship, which is inverse: falling rates mean rising prices.
3.Suresh holds a debenture with a face value of Rs 100 paying 9 percent interest. During the year its market price falls to Rs 98. What total return has he earned per debenture?
- a)Rs 9
- b)Rs 7
- c)Rs 11
- d)Rs 2
Show the answer
Answer: (b) Rs 7
This is the workbook's worked example. "The interest income earned is Rs.9 (9 percent of Rs.100). The capital loss suffered is Rs.2 (Rs.100 − Rs.98). The Total Returns earned is Rs.7 (Rs.9 − Rs.2)."
Where the wrong answers come from:
- Rs 9 counts only the interest. "Without the capital loss, the returns from the investment would have been Rs. 9" — but the loss is part of total return.
- Rs 11 adds the capital loss instead of subtracting it.
- Rs 2 is the capital loss alone.
The lesson the workbook draws: "the component of capital gain or loss in total returns MAKES THE TOTAL RETURNS FROM AN INVESTMENT VOLATILE." For bonds, "the extent of change in the value will depend upon the DURATION of the bond: higher the duration higher will be the gain or loss in value."
Where this is taught
Free preparation for NISM Series XVIIRelated terms
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
- Dynamic bond fundA long-term debt mutual fund category that invests across durations, with the fund manager shortening duration when rates are expected to rise and lengthening it when rates are expected to fall.
- Macaulay duration bucketThe duration band an index provider uses to sort bonds — NIFTY bond indices run six such buckets, from Ultra-Short at 3 to 6 months up to Long Duration above 7 years.
- Positive convexityThe favourable asymmetry of an option-free bond: when yields fall its price rises more than duration predicts, and when yields rise it falls less — so buying convexity is an active fixed income strategy.
- Roll downAn active fixed income strategy that profits from the passage of time: on an upward-sloping yield curve a bond's remaining maturity shortens, its yield falls, and its price rises.
- Fiscal deficit and crowding outWhen a large government fiscal deficit, funded through market borrowing, pushes up market interest rates and squeezes out the amount other borrowers — mainly companies — can raise.
- Guaranteed but variableA return category between fixed and market-linked — the workbook's description of products like PPF, where interest is guaranteed but its rate is reset periodically rather than fixed for the whole tenure.
- Inverted yield curveA yield curve on which short-term interest rates are higher than long-term rates — the reverse of the normal upward slope, read as a signal that the economy may go into recession.