Effective Duration

When you buy a bond, it will have a duration. Bonds are like loans, and the duration represents the amount of time it takes to pay the money back.

So you might purchase a bond with a 5% interest rate and a duration of five years. That means you'll get a 5% return per year for each of the next five years. At the end of five years, the money is paid back and the bond expires.

Some bonds have a clause that lets them get retired early. It's like a parachute for the bond issuer. If they don't need the money anymore, or think they can get a better deal somewhere else, they can "call" the bond, basically buying it back at a set price.

Effective duration measures how this option impacts the price for callable bonds.

You buy a bond with a 10-year duration. But if it's callable after three years, you might not get to hold it for the full decade.

That circumstance is bad for you, because it means you won't get those sweet interest payments for as long. If you've got your 10-year bond and it gets called after four years, that's six years of interest you missed out on.
Because of these factors, the price of the callable bond is heavily impacted by movements in interest rates. If prevailing rates are sitting at 7% and you have a bond paying out at 5%, it's not going to get called. The company has a pretty good deal. If it were to call the bond and issue a new set, instead of paying 5%, it would have to pay 7%. Calling would be a mistake.

But say interest rates plunge to 4%. It might be worth it to call in the 5% bonds and issue a new set paying out 4%. The company would save money with the lower interest rate. It just becomes a question of whether it would be worth the effort.

Effective duration is a mathematical equation that takes all this into account, using the callable bond interest rate and current prevailing rates to describe the impact on the bond's price.