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INTEREST RATE RISK

We have seen that bond prices fluctuate as interest rates change. In other words, bonds exhibit interest rate risk. Bond investors cross their fingers that market interest rates will fall, so that the price of their bond will rise. If they are unlucky and the market interest rate rises, the value of their investment falls.

But all bonds are not equally affected by changing interest rates. Compare the two curves in Figure 3.6. The red line shows how the value of the 3-year, 6 percent coupon bond varies with the level of the interest rate. The blue line shows how the price of a 30-year, 6 percent bond varies with the level of interest rates. You can see that the 30- year bond is more sensitive to interest rate fluctuations than the 3-year bond. This should not surprise you. If you buy a 3-year bond when the interest rate is 5.6 percent and rates then rise, you will be stuck with a bad deal you have just loaned your money at a lower interest rate than if you had waited. However, think how much worse it would be if the loan had been for 30 years rather than 3 years. The longer the loan, the more income you have lost by accepting what turns out to be a low coupon rate. This shows up in a bigger decline in the price of the longer-term bond. Of course, there is a flip side to this effect, which you can also see from Figure 3.6. When interest rates fall, the longer-term bond responds with a greater increase in price.

THE YIELD CURVE

Look back for a moment to Figure 3.2. The U.S. Treasury bonds are arranged in order of their maturity. Notice that the longer the maturity, the higher the yield. This is usually the case, though sometimes long-term bonds offer lower yields.

In addition to showing the yields on individual bonds, The Wall Street Journal also shows a daily plot of the relationship between bond yields and maturity. This is known as the yield curve. You can see from the yield curve in Figure 3.7 that bonds with 3 months to maturity offered a yield of about 4.75 percent; those with 30 years of maturity offered a yield of just over 6 percent.

Why didn t everyone buy long-maturity bonds and earn an extra 1.25 percentage points? Who were those investors who put their money into short-term Treasuries at only 4.75 percent?

Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds for two reasons. First, the prices of long-term bonds fluctuate much more than prices of short-term bonds. Figure 3.6 illustrates that long-term bond prices are more sensitive to shifting interest rates. A sharp increase in interest rates could easily knock 20 or 30 percent off long-term bond prices. If investors don t like

price fluctuations, they will invest their funds in short-term bonds unless they receive a higher yield to maturity on long-term bonds.

Second, short-term investors can profit if interest rates rise. Suppose you hold a 1- year bond. A year from now when the bond matures you can reinvest the proceeds and enjoy whatever rates the bond market offers then. Rates may be high enough to offset the first year s relatively low yield on the 1-year bond. Thus you often see an upwardsloping yield curve when future interest rates are expected to rise.

INTEREST RATE RISK

The risk in bond prices due to fluctuations in interest rates.

YIELD CURVE Graph of the relationship between time to maturity and yield to maturity