What Is a Maturity Risk Premium?

Balance the risks when selecting income investments.

Balance the risks when selecting income investments.

One of the basic concepts of investing for income is to understand that a higher yield always comes with one or more types of risk attached. Maturity risk is a factor with even the safest of investments, and an understanding of the maturity risk premium will help you decide whether it is prudent to select an investment of a different maturity.

Maturity Risk

Fixed-income investment securities -- primarily bonds -- typically pay a fixed rate of interest and the face or principal amount when a bond matures. Available maturities range from 30 days to 30 years. Maturity risk is the potential for interest rates to change while your money is tied up in a bond until it matures. Buying a bond with a longer time to maturity increases the likelihood that interest rates could rise over that period. The maturity risk premium is the extra yield you will earn from buying a bond with a longer time to maturity.

Recognizing Maturity Risk Premium

Maturity risk premium applies to any investment that pays a fixed rate of interest and has a fixed maturity date. Some types of fixed rate investments have other risk factors that overshadow maturity risk. Examples include high-yield corporate bonds, municipal bonds and mortgage-backed securities. The investments for which maturity risk premium is a major factor are those with little or no risk of default or prepayment, such as U.S. Treasury securities and bank certificates of deposit.

Recognizing Maturity Risk Premium

Maturity risk premium can be viewed by comparing the same investment with different maturities. Your bank may pay 4 percent on a one-year CD and 5 percent on a 5-year CD. You earn an extra 1 percent per year to tie your money up for the longer maturity. The market interest rates for Treasury securities of different maturities also indicate the maturity risk premium. At the time of publication, the yield on a 20-year Treasury was 2.13 percent. The yield for a 30-year government bond was 2.53 percent.

Investment Decisions With Maturity Risk

If interest rates are expected to increase, it is not the time to assume maturity risk by going for higher yields on longer-maturity securities. If interest rates are forecast to decline, locking in rates for longer maturities makes sense. The important point to remember is that going for a longer maturity just to get a higher yield puts you at risk of being locked into that yield and missing better investment opportunities.

 

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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