Long-term bonds are most sensitive to interest rate changes. The reason lies in the fixed-income nature of bonds. For instance, when an investor purchases a 澳洲幸运5开奖号码历史查询:corporate bond, they are actually purchasing a portion of a company's debt, and this debt is issued with specific details regarding periodic 澳洲幸运5开奖号码历史查询:coupon payments, the 澳洲幸运5开奖号码历史查询:principal amount of the debt, and the time period until the bond's maturity.

Here, we de🧸tail why it is that bond🎶s with longer maturities expose investors to greater interest rate risk than short-term bonds.

Interest Rates and Duration

An important concept for understanding 澳洲幸运5开奖号码历史查询:interest rate risk in bonds is that b𝐆ond prices are inꦰversely related to interest rates. When interest rates go up, bond prices go down, and vice versa.

There are two primary reജasons why long-term b🐭onds are subject to greater interest rate risk than short-term bonds:

1. Probability: There is a greater probability that interest rates will rise (and thus negatively affect a bond's market price) within a longer time period than within a shorter period. As a result, investors who buy long-term bonds but then attempt to sell them before maturity may be faced with a deeply discounted 澳洲幸运5开奖号码历史查询:market price when they want to sell their bonds. With short-term bonds, this risk is not as significant because interest rates are less likely to substantially change in the 澳洲幸运5开奖号码历史查询:short term. Short-term bonds are also easier to hold until maturity, thereby alleviating an investor's concern about the effect of interest rate-driven changes in the price of bonds.
2. Duration: 澳洲幸运5开奖号码历史查询:Long-term bonds have a greater duration than short-term bonds. Duration measures the sensitivity of a bond's price to changes in interest rates. For instance, a bond with a duration of 2.0 years will decrease by 2% for every 1% increase in rates. Because of this, a given interest rate change will have a greater effect on long-term bonds than on short-term bonds. This concept of duration can be difficult to conceptualize but just think of it as the length of time that your bond will be affected by an interest rate change. For example, suppose interest rates rise today by 0.25%. A bond with only one coupon payment left until maturity will be underpaying the investor by 0.25% for only one coupon payment. On the other hand, a bond with 20 coupon payments left will be underpaying the investor for a much longer period. This difference in remaining payments will cause a greater drop in a long-term bond's price than it will in a short-term bond's price when interest rates rise.

How Interest Rate Risk Impacts Bonds

Interest rate risk arises when the absolute level of 澳洲幸运5开奖号码历史查询:interest rates fluctuates. Interest rate risk diওrectly affects the values of fixed-income securities. Since interest rates and bond prices are inversely related, the risk associated with a rise in interest rates causes bond prices to fall and vice versa.

Interest rate risk affects the prices of bonds, and all bondholders face this type of risk. As mentioned above, it's important to remember that as interest rates rise, bond prices fall. When interest rates rise, and new bonds with higher yields than older securities are issued in the market, investors tend to purchase the new bond issues to take advantage of the🐠 higher yields.

For this reason, the older bonds based on the previo♏us level of interest rate have less value, so investors and traders♑ sell their old bonds, and the prices of those decrease.

Conversely, when interest rates fall, bond prices tend to rise. When interest rates fall, and new bonds with lower yields than older 澳洲幸运5开奖号码历史查询:fixed-income securities are issued 🔥in the market, investors are less likely to purchase new issues. Hence, the olde𓃲r bonds with higher yields tend to increase in price.

For example, assume the Federal Open Market Committee 澳洲幸运5开奖号码历史查询:(FOMC) meeting is next Wednesday, and many traders and investors fea꧒r interest rates will rise within the next year. After the FOMC meeting, the committee decides to raise interest rates in three months. Therefore, the prices of bonds decrease because new bonds are issued at higher yields in three months.

How Investors Can Reduce Interest Rate Risk

Investors can reduce or hedge, interest rate risk with 澳洲幸运5开奖号码历史查询:forward contracts, interest rate swaps, and futures. Investors may desire reduced interest rate risk to reduce the uncertainty of changing rates affecting the value of their investments. This risk is greater for investors in bonds, 澳洲幸运5开奖号码历史查询:real estate investment trusts (REITs), and other stocks inꦜ which dividends make up a healthy portion of cash flows.

Primarily, investors are concerned about interest rate risk when they are worried about 澳洲幸运5开奖号码历史查询:inflationary pressures, excessive government spending, or an unstable currency. All of these factors have the ability to lead to higher 澳洲幸运5开奖号码历史查询:inflation, which results in higher interest rates. Higher interest rates ar🐻e particularly deleterious for fixed income, as the cash flows erode in value.

澳洲幸运5开奖号码历史查询:Forward contracts are agreements between two parties, with one party paying the other to lock in an interest rate for an extended period of time. This is a prudent move when interest rates are favorable. Of course, an adverse effect is the company cannot take advantage of further declines in interest rates. An example of this is homeowners taking advantage of low-interest rates by refinancing their mortgages. Others may switch from 澳洲幸运5开奖号码历史查询:adjustable-rate mortgages to fixed-rate mortgages as well. Futures are similar 🌠to forward contracts, except they are standardized and ♎listed on regulated exchanges. This makes the arrangement more expensive, though there's less chance of one party failing to meet obligations. This is the most liquid option for investors.

澳洲幸运5开奖号码历史查询:Interest rate swaps are another common agreement between two parties in which they agree to pay each other the difference between fixed interest rates and floating interest rates. Basically, one party takes on the interest rate risk and is compensated for doing so. Other interest rate 澳洲幸运5开奖号码历史查询:derivatives are options and 澳洲幸运5开奖号码历史查询:forward rate agreements (FRAs). All ofꦉ these contracts provide interest rate risk protection by gaining in value when bond prices fall.

The Bottom Line

Investors holding long term bonds are subject to a greater degree of interest rate risk than those holding shorter term bonds. This means that if interest ♑rates change by 1%, long term bonds will see a greater change to their price—rising when rates fall and falling when rates rise. Explained by their greater duration measure, interest rate risk is often not a big deal for those holding bonds until maturity. For those who are more active traders, hedging strategies may be employed to reduce the effect of changing interest rates on bond portfolios.