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A:

The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as "bonds". When an investor purchases a given corporate bond, he or she is actually purchasing a portion of a company's debt. This debt is issued with specific details regarding periodic coupon payments, the principal amount of the debt and the time period until the bond's maturity.

Another concept that is important for understanding interest rate risk in bonds is that bond prices are inversely related to interest rates. When interest rates go up, bond prices go down, and vice versa. (If you are unfamiliar with this concept, see Why do interest rates tend to have an inverse relationship with bond prices?)

There are two primary reasons why long-term bonds are subject to greater interest rate risk than short-term bonds:

  • There is a greater probability that interest rates will rise (and thus negatively affect a bond's market price) within a longer time period than within a shorter period. As a result, investors who buy long-term bonds but then attempt to sell them before maturity may be faced with a deeply discounted market price when they want to sell their bonds. With short-term bonds, this risk is not as significant because interest rates are less likely to substantially change in the short term. Short-term bonds are also easier to hold until maturity, thereby alleviating an investor's concern about the effect of interest rate driven changes in the price of bonds.
  • Long-term bonds have greater duration than short-term bonds. Because of this, a given interest rate change will have greater effect on long-term bonds than on short-term bonds. This concept of duration can be difficult to conceptualize, but just think of it as the length of time that your bond will be affected by an interest rate change. For example, suppose interest rates rise today by 0.25%. A bond with only one coupon payment left until maturity will be underpaying the investor by 0.25% for only one coupon payment. On the other hand, a bond with 20 coupon payments left will be underpaying the investor for a much longer period. This difference in remaining payments will cause a greater drop in a long-term bond's price than it will in a short-term bond's price when interest rates rise.

(For more information, read The Basics of the Bond Ladder, Trying to Predict Interest Rates and Evaluating Bond Funds: Keeping it Simple.)

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