Assume you purchase $1,000 of a bond fund. If the bond fund has an average duration of 5 years and general interest rates increase 1% , what is the impact on the value of the bond. What would you expect the $1,000 to be worth?
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When interest rates go up, the prices of fixed-rate bonds go down (since you can now get bonds with higher coupon rates). So the value of a bond fund would go down.
Duration is a measure of the sensitivity of bond prices to interest rates. Mathematically, the relative change in value is approximately equal to the duration times the change in interest rates, or
dV/V ~= D * -dY
So a fund with an average duration of 5 years would go down about 5% (to about $950) if interest rates increased 1%.