Series 65: 2.6.6 Interest Rates And Bond Prices

2.6.6  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 interest rate risk for bond investors. Interest rate 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 this 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. 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 of 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 dura