Interest Rates and Bond Prices
As interest rates rise, the prices of bonds decline in the secondary market, because investors can invest their money in higher paying new issues. This is considered market risk for bond investors. Market risk is greater for long-term bonds than short-term bonds, because there is more opportunity for interest rates to rise over the bond’s life. To reduce market risk, investors could invest in short-term bonds over long-term bonds, because when interest rates rise, the prices of long-term bonds fall faster than the prices of short-term bonds.
Sensitivity to interest rates. Because there is more time for interest rates to move in an undesirable way, the prices of long-term bonds are more sensitive to changes in interest rates than the prices of short-term bonds. Short-term bonds also tend to be more liquid than long-term bonds, because investors don’t have to tie their money up for as long a time period.
We often say that long-term bonds have a higher duration than short-term bonds. Duration is a measure of a bond’s sensitivity to changes in interest rates. A bond’s duration expresses the percentage change in the price of a bond that would result from a 1% change in yield.
A bond with a high duration is more sensitive to interest rate changes than a bond with a low duration. If a bond has a duration of 5, its price will decrease roughly 5% with a 1% increase in interest rates, while a bond’s price will decrease 10% if it has a duration of 10. So, in other words, duration measures the risk of inte