Duration is the most important risk metric for bond investors. It measures how sensitive a bond’s price is to changes in interest rates — the higher the duration, the more the bond’s price moves when rates change. Understanding duration helps you manage the interest rate risk in your fixed income portfolio.
What Is Bond Duration?
Duration measures the weighted average time (in years) to receive all cash flows from a bond — coupons and principal. But its practical use is as a price sensitivity measure:
A bond with a duration of 5 years will fall approximately 5% in price if interest rates rise by 1%.
This relationship is approximate (technically, it’s modified duration that gives price sensitivity), but close enough for practical purposes.
Macaulay Duration vs Modified Duration
Macaulay Duration: The weighted average time to receive cash flows, expressed in years. A bond maturing in 10 years with semi-annual coupons has a Macaulay Duration of less than 10 years (because coupons are received before maturity, reducing the weighted average).
Modified Duration: The Macaulay Duration adjusted by the yield, giving direct price sensitivity:
$$\text{Modified Duration} = \frac{\text{Macaulay Duration}}{1 + \frac{y}{m}}$$
Where y = yield to maturity and m = coupon payments per year.
For most practical purposes, modified duration ≈ Macaulay Duration for investment-grade bonds.
How Duration Works in Practice
| Bond type | Approximate duration | Price change if rates rise 1% |
|---|---|---|
| 3-month Treasury Note | ~0.25 years | ~0.25% fall |
| 2-year Treasury Bond | ~1.9 years | ~1.9% fall |
| 5-year Treasury Bond | ~4.6 years | ~4.6% fall |
| 10-year Treasury Bond | ~8.5 years | ~8.5% fall |
| 30-year Treasury Bond | ~18–20 years | ~18–20% fall |
Example: If you hold VAF (which has a portfolio duration of approximately 5–6 years) and the RBA raises rates by 0.50%, VAF’s unit price may fall approximately 2.5–3.0%.
Key Duration Principles
Higher coupon = lower duration: Bonds that pay larger coupons return more money sooner (via coupons), reducing weighted average time to receive cash flows.
Longer maturity = higher duration: More time until principal is returned increases sensitivity to rate changes.
Zero coupon bonds have duration = maturity: All cash flow is at maturity — maximum sensitivity to rate changes.
Duration of Common Australian Bond ETFs
| ETF | Approximate portfolio duration |
|---|---|
| VAF | ~5–6 years |
| VGB | ~6–7 years |
| VBND | ~7–8 years |
These change as the underlying bond portfolio turns over. Check the fund’s current factsheet for the latest duration figure.
Managing Duration Risk in Your Portfolio
Shorter duration = less interest rate risk:
- Short-term term deposits (1–12 months) have duration close to zero — virtually no interest rate risk
- Short-term bond funds or money market funds have low duration
- Short-maturity Treasury Bonds (1–3 years) have low duration
Longer duration = more upside if rates fall:
- If you believe rates will fall significantly, longer-duration bonds will appreciate more
- 10-year and 30-year government bonds benefit most from rate cuts
Barbell strategy: Hold some short-duration assets (term deposits, money market) and some long-duration bonds — avoiding the middle, capturing the ends of the yield curve.
Duration in a Portfolio Context
For most Australian retail investors:
- VAF/VGB (5–6 year duration): Appropriate for a standard defensive allocation — moderate interest rate risk; performs well in rate-cutting cycles
- Short-term bond fund or term deposits: For capital certainty and minimal rate risk
- Long-duration bonds: Only appropriate if you have a specific view on rate falls and can tolerate significant price fluctuation
In a rising rate environment (like 2022–23), long-duration bonds suffered significant capital losses — VAF fell approximately 12–15% in 2022. In a falling rate environment, the same duration provides meaningful capital gain.
Related Articles
- Yield to Maturity Australia
- Australian Government Bonds Explained
- VAF vs VGB Australia
- Bonds in Retirement Portfolio Australia
- Bonds hub
Frequently Asked Questions
What is a good bond duration for an Australian investor? This depends on your view on interest rates and your risk tolerance. For a stable defensive allocation, VAF/VGB (5–6 year duration) is a common choice — it provides meaningful diversification without extreme rate sensitivity. If capital certainty is paramount, short-duration instruments (term deposits, 1–2 year bonds) minimise rate risk.
What happens to bond prices when the RBA raises interest rates? When the RBA raises rates, newly issued bonds offer higher coupons — existing bonds become less attractive by comparison, and their market prices fall. The longer the bond’s duration, the more its price falls. This is why bond ETFs like VAF declined in 2022 when the RBA raised rates rapidly from 0.10% to 4.35%.
Can bond duration be negative? In standard bonds, no — duration is always positive. Some complex derivatives or leveraged inverse bond products can have effectively negative duration (they rise when rates rise), but these are not relevant for standard retail fixed income investing.
This article provides general financial information only. For advice tailored to your situation, speak with a licensed financial adviser through the ASIC financial advisers register or MoneySmart.