Duration: Longer Bonds, Bigger Moves

OK, so we’ve seen that on a one-year instrument, a one-percentage point rise in rates means a 1% or so drop in value. On a ten-year piece of paper, the same interest-rate move means a 10% decline. Remember that these securities did not pay coupons.

This is telling you what you probably already knew—having your money tied up for a long time, when the market moves against you, is a lot more painful than having it in something that comes due pretty soon. With the short-term paper, you take a little loss, but then you get to reinvest pretty soon at the new, more favorable rate. Not so with the longer-dated stuff.

Did you notice that the percentage move in the notes bore a striking resemblance to their maturities? This was no coincidence. But it’s also the main concept they wanted us to learn that summer at Goldman. It’s called duration, and it measures a bond’s sensitivity to changes in interest rates. It seems like a strange word because it’s supposed to measure price changes, and it sounds like it measures time instead. But as we’ve seen, the two are very closely related. In fact, when the bond doesn’t pay periodic interest (as in our examples), the two are pretty much identical.