In bond investing, what does 'duration' indicate?

Duration is a key concept in bond investing that measures the sensitivity of a bond's price to changes in interest rates. Specifically, it quantifies the amount that a bond's price is expected to change in response to a 1% change in yield. This sensitivity occurs because bond prices and interest rates have an inverse relationship; when interest rates rise, bond prices fall, and vice versa.

There are different types of duration, such as Macaulay duration and modified duration, which provide insight into how long it will take for an investor to receive the bond’s cash flows and how much risk the investor faces due to changes in rates. The greater the duration, the more susceptible the bond is to interest rate fluctuations, which is crucial for investors to understand as they manage interest rate risk in their portfolios.

The total yield on the bond, the annual interest payments, and the maturity period of the bond do not encompass the essence of duration. While these factors play roles in bond valuation and investment returns, they do not specifically address how the price of the bond will react to changes in interest rates, which is the primary focus of duration. Hence, the correct understanding of duration is central to effectively managing and assessing risk in bond investments.