interest rates on comparable-risk bonds rose to 15 percent. You would be stuck with
only $100 of interest for the next 14 years. On the other hand, had you bought a
1-year bond, you would have a low return for only 1 year. At the end of the year, you
would get your $1,000 back, and you could then reinvest it and receive 15 percent, or
$150 per year, for the next 13 years. Thus, interest rate risk reflects the length of time
one is committed to a given investment.
As we just saw, the prices of long-term bonds are more sensitive to changes in in-
terest rates than are short-term bonds. To induce an investor to take this extra risk,
long-term bonds must have a higher expected rate of return than short-term bonds.
This additional return is the maturity risk premium (MRP), which we discussed in
Chapter 1. Therefore, one might expect to see higher yields on long-term than on
short-term bonds. Does this actually happen? Generally, the answer is yes. Recall
from Chapter 1 that the yield curve usually is upward sloping, which is consistent with
the idea that longer maturity bonds must have a higher expected rate of return to
compensate for their higher risk.
168 CHAPTER 4 Bonds and Their Valuation
FIGURE 4-3 Value of Long- and Short-Term 10% Annual Coupon Bonds
at Different Market Interest Rates
Value of
Current Market 1-Year 14-Year
Interest Rate, rd Bond Bond
5% $1,047.62 $1,494.93
10 1,000.00 1,000.00
15 956.52 713.78
20 916.67 538.94
25 880.00 426.39
Note: Bond values were calculated using a financial calculator assuming annual, or once-a-year, compounding.
500
1,000
1,500
2,000
0 5 10152025
Bond Value
($)
14-Year Bond
1-Year Bond
Interest Rate, r
(%)
d
See Ch 04 Tool Kit.xls
for details.
164 Bonds and Their Valuation
