Why Bond Prices Go Up and Down

Step 3: If Long Term Bonds Are So Risky, Why Would Anyone Purchase Them?

Here are some questions and answers that will help illustrate several other important aspects of managing interest rate risk:

If long-term bonds are so risky, why would anyone purchase them?

You might, of course, want to purchase long-term bonds for other reasons. One would be to "lock in" an attractive interest rate for as long as possible, if you think you are not going to sell the bonds before they mature. Also, if you think interest rates are about to decline, buying bonds at the long end positions you for maximum capital gains. That would imply that you consider potential capital gains as important (or more so) than interest yield, and in all likelihood that you intend to resell the bonds before they mature.

One reason is that many investors believe that long-term bonds provide the highest yields (or maximum income). That, however, is not necessarily true. If all other factors are equal, long-term bonds have higher coupons than shorter-term bonds of the same credit quality. But intermediate bonds in the A to AA range often yield as much as AAA bonds with far longer maturities, and they are much less volatile. (Note that this relationship is considered normal. But there are times when interest rates on short maturities are higher than interest rates on longer maturities.)

How do interest rate fluctuations affect the price of a bond if I hold it to maturity?

If you hold bonds to maturity, you recover your principal in full (assuming there has not been a default). No matter what kind of roller coaster ride interest rates take during the life of a bond, its value will always be par when the bond is redeemed. Bonds purchased either above par (premium bonds) or below par (discount bonds) are also redeemed at par. The price of discounts gradually rises to par; the price of premiums falls to par. These changes occur very gradually, in minute annual increments and are reflected in the current price of any bond.

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