🎯 In 30 seconds: A single bond held to maturity pays back its face value on a known date, whatever happens to rates in between. A bond fund never matures, so its price moves with rates forever, but it pays a higher yield after rates rise and spreads risk across hundreds of bonds. Duration is the number that tells you how much a fund drops when rates go up, and roughly how long it takes to earn that loss back.
The one rule behind everything
When interest rates rise, the price of bonds you already own falls. Nobody will pay full price for your 4% bond when new ones pay 5%, so its market price drops until its yield matches. When rates fall, the reverse happens. The bond market page in Investing 101 introduces this; here we put numbers on it.
Duration in plain words
Duration is a single number, measured in years, that captures how sensitive a bond or fund is to rate changes. Two handy readings of it:
- The price rule. For a 1 percentage point rise in rates, the price falls by about the duration in percent. Duration 6 means about a 6% drop. FINRA uses the same rule of thumb.
- The time rule. If you hold a fund for about its duration in years, the higher income after a rate rise roughly makes up for the price drop.
Longer maturities mean higher duration. Higher coupons mean somewhat lower duration. A short-term fund might have a duration of 2 or 3, a broad bond-market fund around 6, and a long-term Treasury fund much higher. You can find the number on any fund’s fact sheet.
Worked example: rates rise 1 point
Alex has $10,000 to put in bonds when rates are 4%. A year later rates jump to 5% and stay there. Compare two choices.
Choice A: a 5-year Treasury note held to maturity. It pays $400 a year. After the rise, with four years left, its market price falls to about $9,645. But Alex never sells. He collects $400 a year and gets $10,000 back at the end. The drop shows on his statement and then disappears.
Choice B: a bond fund with a duration of 6 yielding 4%. Leave aside the first year’s income to keep it simple. The rise knocks the fund down about 6%, to $9,400. From then on it earns about 5% instead of 4%, because it keeps buying new, higher-yielding bonds.
| Years after the rise | Fund: $9,400 growing at 5% | If rates had stayed at 4%: $10,000 at 4% |
|---|---|---|
| 0 | $9,400 | $10,000 |
| 2 | $10,364 | $10,816 |
| 4 | $11,426 | $11,699 |
| 6 | $12,597 | $12,653 |
| 7 | $13,227 | $13,159 |
Around year 6 or 7, close to the fund’s duration, the fund catches up with where it would have been and then pulls ahead. That is the time rule at work. Someone who needs the money in year 2 is hurt; someone holding for 10 years ends up better off.
Side by side
| Individual bond held to maturity | Bond fund or ETF | |
|---|---|---|
| Known end value | Yes, face value on a set date (if the issuer pays) | No; it never matures |
| Diversification | One issuer per bond | Hundreds or thousands of bonds |
| Effect of a rate rise | Price drops but recovers by maturity | Price drops, then higher yield earns it back over about the duration |
| Income | Fixed coupon | Changes as the fund buys new bonds; usually paid monthly |
| Cost to buy | Treasuries cheap; corporate and muni bonds may carry dealer markups | Expense ratio, often low for index funds |
| Minimum | Often $1,000 per bond; Treasuries $100 | One share |
| Selling early | Possible, at whatever the market pays | Any trading day |
Which fits what
- Money with a fixed date (tuition in three years): individual Treasuries or CDs matched to that date remove rate risk. A ladder of several maturities spreads it. See How to buy Treasuries.
- The long-term bond slice of a portfolio: a low-cost broad bond fund is simple and diversified. Pick a duration shorter than the time until you need the money.
- Corporate and municipal bonds: single issuers can default, so owning enough of them to diversify takes a lot of money. Most individuals use funds here.
- A middle path: defined-maturity bond ETFs hold a basket of bonds that all mature in the same year, then pay out and close. They mix fund diversification with a known end date.
For municipal bonds and how to compare tax-free yields with taxable ones, see Comparing yields after tax. To look up a specific muni’s documents and trade prices, the MSRB’s free EMMA site has them.
Checklist before buying bonds or a bond fund
- Write down when you need the money.
- Find the fund’s duration; prefer one shorter than that time.
- Check credit quality: Treasury, investment-grade or high-yield.
- Compare the expense ratio, or ask for the markup on an individual bond.
- For individual corporate or muni bonds, check if the issuer can call (repay) them early.
- A bond fund has a duration of 4. Rates rise 1 point. Roughly how much does its price fall? Answer: About 4%.
- Why does Alex’s Treasury note not lose money if he holds it? Answer: At maturity it pays back the full $10,000 face value regardless of rates.
- About how long did Alex’s fund take to catch up after the rise? Answer: About six to seven years, close to its duration of 6.
- What kind of ETF holds bonds that all mature in the same year? Answer: A defined-maturity bond ETF.