101 Bond Maturities and Interest Rates
Bond Maturities and Interest Rates
Changing interest rates affect bonds with varying maturities differently. Bond prices change with changing interest rates, so the effective yield of a previously issued bond will be more in line with that of current issues. Bonds typically sell for a premium in a declining interest rate environment and typically sell at a discount in a rising interest rate environment. The redemption value at maturity is less for the premium bond and is more for the discount bond. The difference between the purchase price and the redemption price is a component of the bond's yield. The further a bond is from maturity, the greater will be the difference between the purchase price and the redemption value at maturity. Let's look at an example.
Things To Know
- Bonds sell for a premium in a declining interest rate environment and sell at a discount in a rising interest rate environment.
The example
If a bond with a 5 percent coupon and a ten-year maturity is sold on the secondary market today while newly issued ten-year bonds have a 6 percent coupon, then the 5 percent bond will sell for $92.56 (par value $100). The $5 coupon payment (5.4 percent of the $92.56 selling price) plus the additional $7.44 received at maturity ($100 par value – $92.56 = $7.44) produces a 6 percent yield-to-maturity. Now what happens if this 5 percent bond matured in twenty years? It would sell at a discounted price of $88.44 to produce a 6 percent yield-to-maturity. So, when interest rates rise, the longer a bond's maturity, the more a bond seller will discount its price. The shorter the bond's maturity, the smaller the discount.
This also means that when interest rates fall and bonds are sold at a premium, bonds with shorter maturities will have smaller premiums than bonds with longer maturities.
