7.3.3. Yield Curves
Fixed-income securities, such as bonds, are subject to interest rate risk. Interest rate risk is the risk that when interest rates rise, the price of the bond or preferred stock will decline. As you understand by now, when interest rates rise, prices of fixed income securities decline. This is because investors can purchase bonds with the new higher rates, and previously issued bonds, which offer the lower rates, must reduce their prices to remain marketable. Bonds with longer maturities are more vulnerable to interest rate risk than bonds with shorter maturities, because there is a greater chance that interest rates will rise over the bond’s life. Again, greater risk means greater reward.
Bonds with longer maturities tend to pay higher yields than bonds with shorter maturities. This is represented by a typical yield curve depicted below—yield is on the y axis and length of maturity on the x axis. Assuming that investors can tolerate some loss of principal and do not need to remove their money in the near future, an optimal strategy is a mix of maturities. Long-term bonds provide higher yields, a