Assessing the Risk of a Bond (2)
by MaestriThe values of the 1-year and 14-year bonds at several current market interest rates are summarized and plotted in Figure 4-3. Note how much more sensitive the price of the 14-year bond is to changes in interest rates. At a 10 percent interest rate, both the 14-year and the 1-year bonds are valued at $1,000. When rates rise to 15 percent, the 14-year bond falls to $713.78, but the 1-year bond only falls to $956.52.
For bonds with similar coupons, this differential sensitivity to changes in interest rates always holds true—the longer the maturity of the bond, the more its price changes in response to a given change in interest rates. Thus, even if the risk of default on two bonds is exactly the same, the one with the longer maturity is exposed to more risk from a rise in interest rates.12
The logical explanation for this difference in interest rate risk is simple. Suppose you bought a 14-year bond that yielded 10 percent, or $100 a year. Now suppose interest rates on com parable-risk bonds rose to 15 percent. You would be stuck with only $100 of interest for the next 14 years. On the other hand, had you bought a 1-year bond, you would have a low return for only 1 year. At the end of the year, you would get your $1,000 back, and you could then reinvest it and receive 15 percent, or $150 per year, for the next 13 years. Thus, interest rate risk reflects the length of time one is committed to a given investment.
As we just saw, the prices of long-term bonds are more sensitive to changes in interest rates than are short-term bonds. To induce an investor to take this extra risk, long-term bonds must have a higher expected rate of return than short-term bonds.
This additional return is the maturity risk premium (MRP), which we discussed in Chapter 1. Therefore, one might expect to see higher yields on long-term than on short-term bonds. Does this actually happen? Generally, the answer is yes. Recall from Chapter 1 that the yield curve usually is upward sloping, which is consistent with the idea that longer maturity bonds must have a higher expected rate of return to compensate for their higher risk.
Taken From : Five-Minute MBA – Corporate Finance
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