A bond’s interest rate risk is proportional to its duration. Duration is a weighted measure of when you will get your money back, (both interest and principal) from a bond investment. This period is less than the term to maturity of the bond. Duration takes into consideration the present values of all the coupons and principal payment, measuring not only the amounts but also the time in future when they will be received. For instance, the duration of a 20-year zero-coupon bond is its term to maturity—20 years, since all payments are received at that time. Hence in the case of a zero-coupon bond (deep discount bond), the term to maturity and the duration are the same. However the duration of a 20-year, 10% coupon bond would be less than 20 years, since income payments are received prior to maturity.

Let us see how duration is calculated. Consider Rs.100 one-year bond redeemable at par and paying 10% semi-annual interest. The investor gets Rs.5 after six months and Rs. 105 after one year. The time-weighted present value of these cash flows (discounted at 10%) is Rs.97.83. The duration is, hence, 0.978 years (Rs.97.83/ Rs.100).

The factors that determine the duration of a bond are: coupon payments and their frequency, and the maturity period. The following basics should always be kept in mind:

• Bonds with higher coupon payments have lower duration.
• Shorter maturities have lower duration.
• More frequent coupons have lower duration.

Duration can be a useful risk management tool if you have a clearly defined time horizon. A rule of thumb is to match your investing time horizon with the duration of your bond investment. For example, if you're investing money that you want to use for a down payment on a house in two to four years, consider a bond investment with a duration of two to four years.