By purchasing a bond, you lend an organization cash in exchange for the receipt of interest payments at regular intervals until the bond matures. At that time, the bond issuer pays you the principal you loaned the company as well. For instance, if your bond has a two-year maturity, you're scheduled to receive your principal in two years' time.
But the purchase of a bond is not without its risks, such as the interest rate risk. Companies compensate the investor for assuming these risks by paying premiums, such as the default risk premium, the liquidity risk premium and the maturity risk premium.
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Interest Rate Risk
The holder of any bond is exposed to interest rate risk, namely, the likelihood that a change in interest rates will decrease the value of a bond or another fixed-rate investment. For instance, as interest rates rise, demand for bonds falls as does the valuation of existing bonds.
Interest rate risk moves in the same direction as a fixed income security's duration. The more distant the bond's maturity date, the greater the interest rate risk, and the greater sensitivity of the bond's price to interest rate changes.
Importance of Interest Rate Risk
Due to the impact of an interest rate change on a bond's market value, bondholders monitor interest rates and the changes in these rates over time. If interest rates rise, the prices of fixed-income securities fall. If rates fall, fixed-income security prices rise.
When interest rates rise, the opportunity cost of holding bonds increases because if an investor's cash is tied up in a bond, she misses the opportunity to invest in a bond that pays a higher interest rate. Consequently, when bond interest rates rise, companies compensate for the economic disadvantage by paying a maturity risk premium.
If you invest in a 20-year bond, you should receive your principal in 20 years. A long-term bond, however, can lose a little value or a lot of value over time.
For instance, a company that loses its primary customer will suffer a revenue loss as a result. Due to the decreased income flow, the risk of default increases. Because the risk is greater that adverse events will occur during a 20-year term than a two-year term, a 20-year bond is assigned a maturity risk premium. That premium equates to an interest rate that's greater than that of a two-year bond.
When risk rises above that reflected in the bond's fixed rate, investors may switch to a different investment vehicle that poses less risk and that pays an interest rate that more accurately reflects that risk level. Companies whose securities pose a maturity risk attempt to generate demand by paying a maturity risk premium.
The maturity risk premium compensates the investor for buying the long-term bond and, in the process, assuming the greater risk. In general, the longer the bond's term, the greater the maturity risk premium.
The maturity risk premium for a long-term bond takes the form of a higher rate of return for the investor. The higher return compensates the investor for the opportunity cost the bond imposes, namely missed opportunities over time to invest in other securities that pay higher interest rates. The size of the premium reflects the security's term.
To calculate your bond's maturity risk premium, you first identify the bond you'll purchase with the appropriate maturity date. For instance, assume you'll buy a 10-year bond.
Determine the yield for risk-free bonds with the same duration, namely, 10 years. A Treasury bill is a risk-free security that's backed by the U.S. government. Next, subtract the interest for the Treasury bill from the rate for the 10-year Treasury bond. The bond's interest rate represents the minimum risk premium an investor expects to receive in exchange for buying the Treasury bond with a 10-year maturity.
Assume the yield for a one-year Treasury bill is 0.51 percent, and the yield on the 10-year Treasury bond is 1.71 percent. Subtract the 0.51 percent Treasury bill yield from the 1.71 percent Treasury bond yield to equal the 1.2 percent baseline maturity risk premium for a 10- year bond.