In 2022, many investors were shocked to see their “safe” bond funds lose more than 10%. The number that warned them was printed on every fact sheet: duration. This module shows you how to read it and use it, so you know how far a bond or bond fund can fall before it happens.
Module 2 showed that bond prices fall when rates rise. The next question is: by how much? The answer is duration. It is measured in years, but the easiest way to read it is as a multiplier: roughly, the percentage a bond’s price changes for each one-point move in interest rates.
Example. A bond fund has a duration of 7. If interest rates rise by 1 percentage point, for example from 3% to 4%, its price falls by about 7 × 1 = 7%. If rates rise by 2 points, it falls about 14%. If rates fall by half a point, it rises about 3.5%.
The minus sign is the seesaw from Module 2: rates and prices move in opposite directions. Duration tells you how long the seesaw’s arm is.
Three things push duration up. The longer you have to wait for your money, the more a change in rates affects what that money is worth today.
Bond funds are grouped by how long their bonds are, and their durations differ a lot. The ranges below are typical for Canadian bond index funds. Always check the current figure on the fund’s fact sheet.
| Type of bond fund | Bonds maturing in | Typical duration | Estimated move if rates rise 1 point |
|---|---|---|---|
| Short-term | 1 to 5 years | about 2.5 to 3 | about −3% |
| Broad (“universe” or aggregate) | All maturities | about 7 | about −7% |
| Long-term | 10 years or more | about 14 or more | about −14% |
Duration is an estimate, and it works best for small moves. Go back to the five-year, 4% bond from Module 2. Its duration is about 4.45. Here is what duration predicts, and what actually happens:
| Rates move | Duration estimate | Actual price change |
|---|---|---|
| Up 1 point, to 5% | −4.45% | −4.33% (about $956.71) |
| Down 1 point, to 3% | +4.45% | +4.58% (about $1,045.80) |
The real losses are a little smaller than the estimate, and the real gains a little bigger. This curve in the price–yield relationship is called convexity, and for ordinary bonds it works in your favour. For everyday decisions, duration alone is close enough. Just remember that for big rate moves it slightly overstates the loss.
For most of 2020 and 2021, interest rates were close to the lowest levels in history. The Bank of Canada’s policy rate was 0.25%, and government bonds paid very little. Then inflation surged, and in 2022 central banks raised rates faster than they had in decades. The Bank of Canada took its rate from 0.25% to 4.25% in under a year, and the US Federal Reserve moved just as fast.
Longer-term bond yields followed. Over the year, yields on Canadian government bonds rose by roughly two percentage points or more. Now apply duration:
| Step | Rough figure |
|---|---|
| Duration of a broad Canadian bond index | about 7 to 7.5 |
| Rise in yields over the year | about 2 points |
| Price change from duration (7.5 × 2) | about −15% |
| Interest earned during the year | about +2% to +3% |
| Total return | about −12% |
That is roughly what happened. The broad Canadian bond market lost about 12% in 2022, and the broad US bond market about 13%, the worst calendar years for bonds in decades. Long-term bond funds, with durations of 14 or more, lost far more.
Three things made 2022 so painful: yields started extremely low, so there was little income to cushion the fall; durations were high, partly because yields were so low; and rates rose very fast. Nothing about it was hidden. The duration on the fact sheet said how sensitive these funds were.
There is a reason duration losses are not the whole story. When rates rise, the bond fund’s price falls, but from then on it earns the new, higher yield, because it reinvests its coupons and maturing bonds at higher rates.
Example. You have $10,000 in a bond fund with a duration of 7, yielding 2%. Rates rise by one point overnight. Compare that with a world where rates stayed put.
| Year | Rates stay at 2% | Rates jump to 3% (−7% first, then 3% a year) |
|---|---|---|
| Start | $10,000 | $9,300 |
| 3 | $10,612 | $10,162 |
| 5 | $11,041 | $10,781 |
| 8 | $11,717 | $11,781 |
In this simple example, the investor who suffered the rate shock catches up after about seven and a half years, close to the fund’s duration, and is ahead after that. In real life rates rarely jump once and then sit still, so treat this as a rule of thumb: if you can hold for about the duration, a rate rise mostly hurts now and pays you back later.
Put the last two sections together and you get the most useful rule in this course: the duration of the bonds you hold should not be much longer than the time until you need the money.
Educational purposes only; not financial advice. Any bonds, funds, tickers, rates and figures are illustrative examples, not recommendations. Interest rates, deposit-insurance limits and tax rules change, so confirm current details with the issuer, CDIC and your tax authority. Worked examples are not forecasts. Written by Elizabeta Dimoska. Always do your own research and consult a licensed advisor.