You know that bond prices fall when interest rates rise. But by how much? That depends on duration. Two bonds with the same face value and coupon can have very different price sensitivities — a 30-year government bond is devastatingly sensitive to rate moves; a 2-year bond barely flinches.
Macaulay Duration vs Modified Duration
Macaulay Duration is the weighted average time until all the bond's cash flows are received, measured in years. It weights each cash flow by its present value as a proportion of the total bond price. A zero-coupon bond's Macaulay Duration equals its maturity (no intermediate cash flows). A coupon-paying bond's duration is always less than its maturity.
Modified Duration = Macaulay Duration / (1 + YTM). This is the practical measure of price sensitivity:
A bond with Modified Duration 8 falls ~8% in price for each 1% rise in rates.
What drives duration
| Factor | Effect on Duration | Why |
|---|---|---|
| Longer maturity | Higher duration ↑ | More cash flows far in the future |
| Higher coupon | Lower duration ↓ | More cash flows in the near term |
| Higher yield | Lower duration ↓ | Discounts future flows more heavily |
Duration and the 2022 bond crash
The 2022 rate hiking cycle — from near-zero to 5%+ in 12 months — caused the worst bond market crash in decades. Portfolios heavily weighted towards long-duration bonds (20-30 year government debt) fell 30–40%. The UK pension fund crisis in autumn 2022 was triggered by LDI (liability-driven investment) strategies using leverage in long-duration gilts — when rates spiked, the duration exposure caused catastrophic losses that required Bank of England intervention.
What this means for you
If you own bond funds, check their stated duration. A "long bond" fund with duration 15 is taking on enormous interest rate risk — useful if you expect rates to fall (duration acts as leverage), dangerous if rates rise. "Short duration" funds (duration 1-3) are much more defensive. In a rising rate environment, short duration bonds significantly outperform long duration ones — regardless of credit quality.