2.6  Interest Rates and Bond Prices

As interest rates rise, the prices of bonds decline in the secondary market because investors can invest their money in higher paying new issues. This is considered market risk for bond investors. Market risk is greater for long-term bonds than short-term bonds because there is more opportunity for interest rates to rise over the bond’s life. To reduce market risk, investors could invest in short-term bonds over long-term bonds because when interest rates rise, the prices of long-term bonds fall faster than the prices of short-term bonds.

Sensitivity to interest rates. Because there is more time for interest rates to move in an undesirable way, the prices of long-term bonds are more sensitive to changes in interest rates than the prices of short-term bonds. Another way to say this is that long-term bonds have a higher duration than short-term bonds. Duration is a measure of a bond’s sensitivity to changes in interest rates.

A bond’s duration expresses the percentage change in the price of a bond that would result from a 1% change in yield. A bond with a high duration is more sensitive to interest rate changes than a bond with a low duration. For example, if a bond has a duration of 5, its price