2.4.6 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 duration of 5