Question

Describe how the maturity and coupon on a security affect its sensitivity to interest rates.

Answer 1

US government issued bonds typically have low credit risk. Treasury bonds (as well as other types of fixed income investments) are, however, sensitive to interest rate risk, which refers to the possibility that a rise in interest rates will cause the bond 's value to fall. Bond prices and interest rates move in opposite directions, because as interest rates fall, the value of investment in fixed income increases, and when interest rates increase, the value of bond prices decreases.

If rates rise and you sell your bond before it's due date (the date your investment principal is scheduled to be returned to you), you might end up receiving less than what you paid for your bond. Similarly, if you own an exchange-traded bond fund or bond fund ( ETF), its net asset value will decline if interest rates rise. The degree to which the values will fluctuate depends on several factors, including the date of maturity and the coupon rate on the bond or the bonds held by the fund or ETF.

Duration is expressed in terms of years, but the maturity date of a bond isn't the same thing. That said, one of the key components in the figuring duration is the maturity date of a bond, as is the coupon rate for the bond. In the case of a zero-coupon bond, the remaining time of the bond to its date of maturity is equal to its duration. However when a coupon is attached to the bond, the period number of the bond will still be lower than the date of maturity. The bigger the coupon, the shorter the amount of the length would become.

Bonds with long maturities and small coupons typically have the longest durations. Such bonds are more prone to market interest rate changes, and are thus more volatile in a changing rate setting. Conversely, there would be shorter durations for bonds with shorter maturity dates or higher coupons. In a changing rate environment, bonds with shorter durations are less sensitive to changing rates and are thus less volatile.