Most people understand that equities can fall — sharply and without warning. Fewer understand that bonds can too. The 2022 bond market sell-off delivered some of the worst annual returns for government bonds in modern history, with long-dated UK gilts losing more than 40% in sterling terms over the course of the year. For investors who held bonds as a "safe" counterweight to equities, the experience was disorienting.
Understanding why this happened — and what it means for your portfolio — requires understanding duration.
The basic mechanics: why bond prices move at all
When you buy a bond, you are lending money to a government or company in exchange for a series of fixed interest payments (coupons) and the return of your principal at maturity. The coupon rate is fixed when the bond is issued.
If interest rates in the market rise after you buy the bond, new bonds will be issued with higher coupons. Your existing bond — paying its lower fixed coupon — is now less attractive compared to the alternatives. For the market to adjust, the price of your bond falls until its effective yield matches the market rate.
The reverse is also true: when interest rates fall, existing bonds with higher coupons become more attractive, and their prices rise.
This inverse relationship — rising rates, falling prices; falling rates, rising prices — is the fundamental dynamic of fixed income investing.
Duration: the measure of sensitivity
Duration is the metric that tells you how sensitive a bond's price is to interest rate changes. It is expressed in years.
The rule of thumb: a bond with a duration of 10 years will lose approximately 10% of its value if interest rates rise by 1 percentage point (and gain approximately 10% if rates fall by 1 percentage point).
A 30-year UK gilt, for example, might have a duration of 18–20 years. A 2-year government bond might have a duration of 1.8 years. The long-dated bond is roughly 10 times more sensitive to rate changes than the short-dated one.
Why does duration differ from maturity? Because duration weights the timing of all cash flows — coupons and principal repayment — into a single number. A bond paying large coupons early has lower duration than a zero-coupon bond of the same maturity, because you receive cash sooner and are therefore less exposed to the discount rate over a long period.
Why 2022 was so painful
In 2022, central banks — the Bank of England, the US Federal Reserve, the European Central Bank — raised interest rates faster than at almost any point in post-war history, responding to inflation that reached multi-decade highs.
For bond investors, the result was devastating. Long-dated government bonds had durations of 15–25 years, and rates rose by several percentage points. The maths was unforgiving: a bond with duration of 20 years, in a market where rates rose by 3 percentage points, lost approximately 60% of its value in price terms (offset partially by coupon income, but not completely).
The conventional 60/40 portfolio (60% equities, 40% bonds) — designed partly on the assumption that bonds would rise when equities fell — experienced the unusual phenomenon of both asset classes falling simultaneously. This happens when the dominant risk factor is inflation rather than recession: central banks raise rates to fight inflation, hurting bonds, while higher rates and economic slowdown also hurt equities.
Short vs long duration: the strategic choice
Managing duration exposure is the primary tool for managing interest rate risk in a bond portfolio.
Short duration strategies (holding bonds maturing within 1–3 years) have very low sensitivity to interest rate changes. They also offer lower yields in normal circumstances — you are compensated less for lending for a shorter period. In a rising rate environment, short-duration portfolios can reinvest at higher rates quickly as bonds mature.
Long duration strategies offer higher yields and benefit significantly when rates fall — the price appreciation on long-dated bonds in a rate-cutting cycle can be substantial. They are more volatile and carry significant capital risk if rates rise unexpectedly.
A practical portfolio approach:
- For investors seeking capital stability and regular income: tilt towards shorter durations
- For investors seeking total return potential and willing to accept volatility: longer durations can add value in periods of falling rates
- For investors uncertain about the rate outlook (which is most investors, most of the time): a laddered approach — spreading maturities across 1, 3, 5, 7, and 10-year bonds — provides a balance
Corporate vs government bonds
Corporate bonds carry credit risk in addition to interest rate risk. The yield on a corporate bond includes both compensation for duration and a credit spread — extra yield for the risk that the company might default.
In rising rate environments, corporate bonds are affected by rate rises in the same way as government bonds (through duration), but the credit spread can work as a partial offset: if the economy remains strong, credit spreads often stay tight, and the corporate bond yields less damage than the pure rate rise would suggest. In a severe recession, credit spreads widen sharply, adding losses on top of any interest rate impact.
High yield bonds (issued by lower-rated companies) behave more like equities than investment-grade bonds. Their credit spreads dominate over duration, and their prices tend to fall in recessions and equity downturns rather than moving inversely to them.
The role of bonds in 2026
With interest rates having risen significantly from near-zero levels, bonds in 2026 offer real (inflation-adjusted) positive yields in most developed markets for the first time in over a decade. This changes the calculus: bonds are no longer a return-free risk asset; they are once again a genuine income-generating asset class that also provides portfolio diversification.
The key question for portfolio construction is whether the inflation environment stays benign. If it does, fixed income with moderate duration provides both income and diversification. If inflation reaccelerates and rates rise again, duration exposure will hurt — making shorter-duration allocations the more cautious positioning.
Bond funds vs individual bonds
Individual bonds held to maturity eliminate the capital loss problem: if you hold a bond until it is repaid, you get your principal back regardless of what prices did in between. For direct investors, building a bond ladder — a portfolio of bonds maturing at regular intervals — provides predictable cash flows and eliminates forced selling at depressed prices.
Bond funds are different: they typically do not hold to maturity and must mark their portfolios to market daily. A bond fund's NAV falls when rates rise, regardless of whether the underlying bonds would eventually repay their principal. This means bond fund investors can lose capital even on high-quality bonds in rising rate environments.
For most investors, funds remain appropriate (the diversification and liquidity benefits are real) but understanding what the fund's duration implies is important when constructing a portfolio.
Duration is an estimate, not a promise
The rule of thumb above is a linear approximation, and like most linear approximations it works best for small movements. For large rate moves it becomes progressively less accurate, and the error is not symmetrical: the price gain from a large fall in rates tends to exceed the price loss from an equally large rise. That curvature is a real property of most conventional bonds, and it is the reason a duration figure should be read as a guide to sensitivity rather than as a precise forecast of what a portfolio will do.
The approximation carries a second, larger assumption. It treats a rate change as a uniform shift affecting every maturity equally, when in practice short and long rates frequently move by different amounts and occasionally in different directions. A portfolio's actual outcome depends on where along the curve its holdings sit, not merely on their average duration. Two funds quoting the same duration can behave quite differently if one holds mostly short bonds alongside a few very long ones and the other holds everything in the middle.
Questions worth asking about a bond fund
Because a fund's behaviour is driven by characteristics that are not always prominent in its marketing, a short checklist does most of the work:
- What is the fund's duration today, and how much has the manager varied it historically? A fund that moves duration actively is making a rate call on your behalf.
- What is the credit quality mix, and how much sits below investment grade? That proportion does more to determine how the fund behaves in a downturn than its duration figure does.
- Which yield is being quoted? A distribution yield describes what the fund has recently paid out, which reflects the coupons on bonds bought in the past. A yield to maturity describes what the current holdings would deliver if held to redemption with nothing defaulting. After a period of rising rates the two can diverge widely, and it is the second that indicates what the fund is now positioned to earn.
- What are the ongoing charges relative to the yield? A cost that is trivial against equity return expectations is not trivial against a bond yield.
Why this matters more for internationally mobile investors
Someone who earns, spends and retires in one currency can treat a domestic bond fund as a relatively straightforward holding. Someone whose income arises in one currency and whose future liabilities arise in another cannot, because the fixed income part of a portfolio is usually held for stability, and an unhedged currency exposure removes precisely the stability it was bought for.
The general principle is to match the currency of low-risk assets to the currency of the liabilities they are intended to meet, and to accept currency risk, where you take it at all, in the parts of the portfolio expected to generate growth. That is a structural decision rather than a market call, and it is worth revisiting whenever a move between countries changes where your future spending will actually occur. Our guide to currency risk management for expats covers the practical tools.
This article is for general information only and does not constitute investment advice. Bond prices can fall as well as rise. Past performance is not a reliable guide to future returns. Contact us to discuss how fixed income fits into your investment strategy.
This article is for general information only and does not constitute financial, legal or tax advice. Rules, prices and regulations change; verify current requirements with a qualified adviser before acting.