the same, the one with the longer maturity is typically exposed to more risk from
a rise in interest rates.13.4 The prices of long-term bonds are more sensitive to changes in interest 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). Therefore, one might
expect to see higher yields on long-term than on short-term bonds.
13.5 The longer maturity bonds must have a higher expected rate of return to
compensate for their higher risk.
- Reinvestment Rate Risk
14.1 As we saw in the preceding section, an increase in interest rates will hurt bond
holders because it will lead to a decline in the value of a bond portfolio. But can a
decrease in interest rates also hurt bondholders? The answer is yes, because if
interest rates fall, a bondholder will probably suffer a reduction in his or her
income. For example, consider a retiree who has a portfolio of bonds and lives
off the income they produce. He has to replace with lower-yielding bonds and
suffer reduction in income.
14.2 The risk of an income decline due to a drop in interest rates is called
reinvestment rate risk, and its importance has been demonstrated to all
bondholders in recent years as a result of the sharp drop in rates since the mid
1980s. Reinvestment rate risk is obviously high on callable bonds. It is also high
on short maturity bonds, because the shorter the maturity of a bond, the fewer the
years when the relatively high old interest rate will be earned, and the sooner the
funds will have to be reinvested at the new low rate. Thus, retirees whose
primary holdings were short-term bonds were hurt badly by the recent decline in
rates, but holders of long term bonds are still enjoying their old high rates.
Another important risk associated with bonds is default risk. If the issuer
defaults, investors receive less than the promised return on the bond. Therefore,
investors need to assess a bond’s default risk before making a purchase. The
greater the default risk, the higher the bond’s Yield to maturity. The default risk
on Treasury securities is Zero, but default risk can be substantial for corporate and
municipal bonds.
14.3 Suppose two bonds have the same promised stream of cash flows, coupon rate,
maturity, liquidity, and inflation exposure, but different levels of default risk.
Investors will naturally pay less for the bond with the grater chance of default. As
a result, bond with higher default risk will have higher interest rates. If its default
risks changes, this will affect the price of a bond.