Course: Investment Planning
Lesson 10: Fixed Income Securities Analysis

Student Question:

I’m not clear why holders of long-term bonds are subject to interest rate risk. If a 20-year bond is purchased at par with a coupon rate of 6.25% ($62.50/year), it seems to me that the investor would still receive $62.50 a year regardless of interest rate changes. What am I missing?

Michael


Instructor Response:

Hi Michael,

Thank you for your question.  All bonds, even Treasury Bonds, are subject to interest rate risk.   Even if the bond and its interest payments have no default risk, interest rate risk exists.

  • Bond prices are inversely related to market interest rates. 
  • A rise in interest rates generally results in a reduction in the market value of a fixed income security such as a bond.
  • Long-term bonds (high duration) are more susceptible to interest rate risk than short-term bonds (low duration).
  • For example:
    • The market value of a 10-year publicly traded bond could fall about 7.5% if market yields increase just one percent; a bond trading at $1,000 before the yield increase would trade at about $750 after the 1% yield increase.
    • The market value of a 90-day T-bill would see virtually no change in market value as a result of an increase in 10-year bond yields of 1%.

The reverse is also true.  If market yields fall, the market value of a bond would tend to increase.  The longer the bond’s duration, the more the increase in the bond’s market value. 

Does that help answer your question?

Bruce

Student Response:

Bruce,

Thanks for the explanation.  If I’m understanding correctly you are saying that my bond will still receive $62.50 a year but should I desire to sell mine or purchase a new one after a market yield increase of 1%, the price to sell/purchase would be $750.  Is that correct?

Michael

Instructor Response:

You understand perfectly, Michael. Well done.

Bruce