Question

First, explain the concept of a Maturity Risk premium for bonds. Second, in terms of risk, what is the “big takeaway” from this concept?

Answer 1

Answer: Risk is not what we can associate with loss or a downfall it is purely the uncertainty that is there associated with time. We know that if we invest in short term bond / fixed income security there interest rates are pretty low. We can associate such low interest rate to less degree of uncertainty in three months, six months or one year instruments. This uncertainty can be linked to change in economical, political or market factors which can be highly uncertain in a longer time frame than in a shorter one. This higher pricing in Interest Rate for Long Duration Bonds / Fixed Income Securities to Short Term Bonds / Fixed Income Securities is what Maturity Risk Premium is all about. The difference of two maturities one short term and another long term risk free instruments say treasury bonds can form the base of Maturity Risk Premium. It means if we invest in one year treasury bond yielding suppose 1.00% and ten year treasury bond yielding 2.50% then the difference of 1.50% is the base of Maturity Risk Premium.

Biggest takeaway from this concept is that if we are investing in longer term bonds than we have to be prepared to pay the extra for the uncertainty that longer time holds for the instrument. It can benefit our investment if Interest Rates soften in future or can be adverse to us if Interest Rates go up because we may have invested at lower interest rate.

It is better to be investing in Fixed Income securities or Bonds upto 3 years period and then one can roll to pay a just Market Risk Premium.