Since the typical investment bond pays a fixed rate of interest each year, the mechanism to adjust for changing rates is to change the market price of a bond. How much a bond's price could change depends on several factors. The concept of duration gives an estimate of a bond's potential price sensitivity.
Rates and Prices
Bonds have an inverse relationship between yields and prices. Rising interest rates result in lower bond prices and declining interest rates cause bond prices to increase. As an example, you own a bond which pays 6 percent -- the coupon rate -- per year. If rates for similar bonds rise to 8 percent, the market price of your bond will fall until that price results in an 8 percent yield from the 6 percent coupon payment. If rates fell to 5 percent, your bond would increase in value and sell at a premium to the face amount.
Rules of Thumb
How much a bond price changes depends on several factors. Several rules of thumb can be used to compare the investment potential of different bonds. For the same change in rates, longer-term bonds will experience a larger price change than short-term bonds. High coupon bond prices are less sensitive to price changes than low coupon bonds. If you expect rates to fall, buy bonds with the greatest potential for price changes. If you think rates will rise, buy bonds with defensive characteristics, such as short maturities and high coupon rates.
Duration is a mathematical calculation which includes all of the factors that affect a bond's price: time to maturity, coupon yield and market rates. Mathematically, duration measures the time it would take to recover the invested amount from interest and principal cash flows. The calculated duration number accurately estimates the price change of a bond resulting from a 1 percent change in interest rates. The duration of a portfolio of bonds, such as a bond fund, shows the overall rate sensitivity of the entire portfolio.
Bonds Vs. Bond Funds
An investor holding individual bonds always retains the option to hold a bond until it matures and receives the full value. A change in the market price only matters if you want to sell the bond. In a bond fund, the share price change indicated by the duration value can be viewed as a close to permanent effect if interest rates change. Only a reversal in rates would reverse the change in a bond fund's share price.