2.7.  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, also called interest rate 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 life of a long-term bond. To reduce market risk, bond investors could sell longer-term bonds and invest instead in shorter-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. Because of their lower risk and greater liquidity, short-term bonds typically pay lower yields than long-term bonds with similar credit ratings.

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; a bond with