Bonds are debts issued by governments and corporations. When you buy a bond, you are, in effect, lending money. Bondholders expect to be repaid at a certain date (the maturity date) and earn interest at a stated rate. Once a bond is issued, it can be traded on a bond exchange or by bond dealers. In either case, the price of the bond varies with supply and demand.
Demand can change when interest rates rise or fall, and maturity risk premium is one-way investors protect themselves from falling bond prices. A maturity risk premium is defined as the process by which investors demand a lower price and consequently a higher yield for bonds with extended maturation periods.
A maturity risk premium is a reduced price and subsequent increased yield on a bond that has an extended maturation period.
The Basics of Bonds
Bonds are issued with a “face” amount, which is how much the bondholder will receive from the issuer when the bond matures. Most bonds pay a fixed interest rate, usually in quarterly or semi-annual installments. For example, a bond might be issued with a face value of $10,000, paying 6 percent interest annually in semi-annual installments and maturing in 10 years.
This bond will make 20 payments of $300 interest, one every six months, and pay $10,000 in 10 years from the date of issue. The bond buyer will not necessarily pay $10,000 to buy the bond, because the price depends on current interest rates.
Price Versus Yield
Bond current yield is how much annual income an investor expects from a bond. It’s expressed as a percentage of the bond’s price. For example, if a bond pays annual interest of $600 and sells for $9,500, its current yield is 6.32 percent. Compare this to the yield of 6 percent ($600 / $10,000) if the bond was selling for its face value of $10,000. In other words, the yield increases as the bond price decreases.
Interest Rate Risk
When you buy a bond, you take on the risk that interest rates will rise before the bond matures. That would stick you with a bond that is paying below-market rates. You can sell the bond, but because the price will be determined by the current yield on new, similar bonds, you will likely have to sell it for less than what you paid.
That’s a risk that increases with time, because the longer the wait until maturity, the greater the chance that interest rates will change. This is called maturity risk, a form of interest rate risk. If you plan to hold the bond until maturity, you don’t care about a price drop, because you know you will receive the face value at maturity. However, you might care about missing out on higher available interest rates.
Maturity Risk Premium
Bondholders protect themselves from rising interest rates by demanding a lower price and therefore a higher yield on bonds with longer maturity dates. The increase in required yield due to longer maturity is called the maturity risk premium. It’s how much additional yield you will demand by offering a lower purchase price on bonds with longer maturities. All things being equal, bonds with longer maturity dates must provide higher yields and lower prices in order to compete with shorter-maturity bonds.
Maturity risk premium is one of several factors that determine a bond’s price. Other risks include the chance that the bond issuer will fail to make its payments and the risk that you won’t be able to quickly find a buyer for the bond when you want to sell it, forcing you to lower your asking price.