Introduction

Understanding the influence of maturity on bond prices and returns is essential for anyone involved in fixed-income investments. The maturity of a bond, which represents the length of time until the bond’s principal is repaid, has a profound effect on its valuation and the returns it generates. In this chapter, we will delve into the various aspects of how bond maturities impact prices and returns, providing you with valuable insights for making informed investment decisions.

Bond Maturity and Bond Prices

One of the fundamental principles in bond investing is that there is an inverse relationship between bond prices and their yields. As bond maturity increases, the sensitivity of bond prices to changes in interest rates also increases. This means that longer-maturity bonds are generally more price-sensitive to interest rate fluctuations compared to shorter-maturity bonds.

Duration and Convexity

• Duration: Duration is a measure of the weighted average time to receive the bond’s cash flows, including both coupon payments and the principal repayment at maturity. It provides an estimate of a bond’s interest rate risk.

• Convexity: Convexity measures the curvature of the bond’s price-yield curve. It helps refine the estimate of a bond’s price change in response to interest rate changes, especially for larger interest rate movements.

Example: Consider two bonds, Bond A with a maturity of 5 years and Bond B with a maturity of 15 years. If interest rates increase by 1%, Bond B will experience a larger percentage decrease in price compared to Bond A due to its longer maturity and higher duration.

Bond Returns and Yield to Maturity (YTM)

The yield to maturity (YTM) is a critical metric for assessing bond returns. YTM represents the total return an investor can expect to receive if they hold the bond until maturity and reinvest all coupon payments at the YTM. YTM considers both the bond’s current price and the future cash flows, making it a useful tool for comparing bond investments of different maturities.

Yield Curve Shape and Maturity

The shape of the yield curve, which represents the relationship between interest rates and bond maturities, can provide insights into future interest rate movements. An upward-sloping yield curve suggests that longer-maturity bonds have higher yields, while a flat or inverted yield curve may indicate expectations of future interest rate decreases.

Example: An inverted yield curve, where short-term interest rates are higher than long-term rates, often precedes economic recessions. Investors may interpret this as a signal to favor shorter-maturity bonds or adopt defensive strategies.