Why are bonds with longer maturities more sensitive to interest rate changes?
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Bond investments represent an important asset class available to investors. Thus, understanding the key factors that influence bond prices will help investors better manage their overall investments. Show Bonds are debt instruments issued by corporations for a period of more than one year for the purpose of financing their capital expenditures. Bonds can be issued by governments, quasi government institutions, financial institutions, corporations and other types of institutions. Bond investors receive interest payments which are called coupon payments. At the end of the bond’s maturity period, investors will receive the principal repayment. The value of a bond is the present value of the stream of cash flows comprising coupon payments and principal repayment. This valuation is obtained by discounting the bond’s expected cash flows to the present using an appropriate discount rate. The discount rate used should be reflective of current market yields for bonds with similar maturities and credit rating. To illustrate the computation of a bond’s value, the example shown in Table 1 is used. A 5-year AA-rated Corporate Bond has a coupon rate of 4.50% and matures in 5 years with a maturity value or par value of RM1,000. A discount rate of 5%, which is reflective of current market yields for similar bonds, is used to discount the bond’s cash flows. Cash flows from coupon payments received at the end of each of the five years are shown in column A of Table 1. At the end of the fifth year when the bond matures, the principal repayment is received as shown in Column B. The total cash flows received by the bondholder which is the sum of Column A and B are shown in Column C. The discount factor which is used to discount the bond’s cash flow is shown in Column D. The net present value of the stream of cash flows (Column E) is obtained by multiplying the cash flow received by the respective discount factors for each year. Table 1: Computing the Net Present Value of Cash Flows of a 5-year AA-rated Corporate Bond Coupon Principal Repayment Total Cash Flows Discount Factor* Net Present Value of (RM) (RM) (RM) (RM) [A] [B] [C] [D] [E] = [C] x [D] Year 1 45 - 45 0.952 42.86 Year 2 45 - 45 0.907 40.82 Year 3 45 - 45 0.864 38.87 Year 4 45 - 45 0.823 37.02 Year 5 45 1,000 1,045 0.784 818.78 Total: 225 1,000 1,225 978.35 *The discount factor is the inverse of the discount rate compounded by the respective Based on a discount rate of 5%, the value of the 5-year bond bearing a coupon rate of 4.5% should be equal to the total net present value of its cash flows of RM978.35. During the life of a bond, its price or valuation may change depending on various factors which include the following: 1. Change in Interest Rates The price of a bond moves inversely to market interest rates. This relationship is due to the fact that the discount rate used to compute the net present value of cash flows from a bond is based on prevailing market interest rates. When market interest rates move up, the discount rate of a bond rises, causing the value of the bond to fall as the cash flows are discounted at a higher discount rate. Conversely, a bond’s value rises when market interest rates decline as the corresponding cash flows are discounted at a lower discount rate. 2. Bond Coupon Rate If a bond's coupon rate is below the market yield, the bond will trade below its par value i.e. at a discount. This happens because investors will require the yield of the bond to be in line with existing market yields. This means the bond price will decline to the level where its yield is equivalent to current market yields of bonds of similar credit ratings and maturities. If a bond's coupon rate is above the market yield, the bond will trade above its par value or at a premium. This occurs as investors are willing to pay a higher price to achieve the additional yield. Remember that as the yield decreases, the bond’s price increases. 3. Bond Maturity The prices of bonds with a longer term to maturity are more sensitive to changes in interest rates. Prices of bonds with longer maturities will decline by a larger magnitude as compared to bonds with shorter maturities when interest rates rise. Similarly, prices of bonds with longer maturities will rise by a larger magnitude as compared to bonds with shorter maturities when interest rates decline. 4. Bond Credit Rating The bond credit rating system helps investors to determine the issuer’s credit risk profile. A higher credit rating indicates that the issuer has a stronger capacity to service the bond’s coupon payments or principal repayment on a timely basis, while a lower credit rating indicates a weaker capacity of the issuer to service its coupon payments and principal repayment. Hence, bond issuers with lower credit ratings have to offer higher yields to attract investors given the higher risk involved and vice versa. A change in a bond’s credit rating can impact a bond’s price. If the bond’s credit rating is lowered, the value of the bond will decline and its yield increases. Alternatively if the credit rating is raised, the value of the bond will rise and the yield declines. Despite changes in a bond’s valuation due to movements in interest rates over the life of a bond, an investor who holds a bond from issue date to maturity will receive the total amount of coupon and principal repayment as originally stipulated over the life of a bond. Similarly, long term investors in bond funds will be able to ride through fluctuations in bond valuations as a result of movements in interest rates as the fund will receive the coupons and principal repayments held by its bond portfolio in full over the longer term. In summary In view of potential movements in bond prices, it is advisable that investors have an understanding of the factors which impact the value of bond investments. Investors should be aware that they need to take a longer term perspective when investing in bonds or bond funds. Although changes in market conditions such as interest rates may result in fluctuations in bond valuations, such fluctuations should even out over the longer term. What characteristics make a bond more sensitive to interest rate changes?Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations.
Does the interest rate sensitivity of a bond increases with its maturity?Generally, the longer the maturity of the asset, the more sensitive the asset to changes in interest rates. Changes in interest rates are watched closely by bond and fixed-income traders, as the resulting price fluctuations affect the overall yield of the securities.
How does the maturity of a bond affect its interest rate?The longer a bond's maturity, the more chance there is that inflation will rise rapidly at some point and lower the bond's price. That's one reason bonds with a long maturity offer somewhat higher interest rates: They need to do so to attract buyers who otherwise would fear a rising inflation rate.
Why does interest rate risk increase with maturity?The larger duration of longer-term securities means higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer-term securities are typically higher than rates on shorter-term securities. This is known as the maturity risk premium.
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