![]() ![]() Long-term rates are not always higher than short-term rates, however. This typical shape reflects the risk premium for holding longer-term debt. In other words, the longer term the bond, the greater is the interest rate. The general shape of that graph is called the shape of the yield curve, and typically the curve is rising. ![]() This relationship between interest rates for loans or bonds and various terms to maturity is often depicted in a graph showing interest rates on the vertical axis and term to maturity on the horizontal. This tendency of long rates to exceed short rates is called the risk-premium theory of the yield structure. To compensate for that risk of price fluctuation, longer-term bonds usually have higher interest rates than shorter-term issues. The longer the maturity of the bond, the greater is the risk of loss because long-term bond prices are more volatile than shorter-term issues. But if you have to sell prior to maturity, you may receive less than you paid for the bond. If you hold a bond to maturity, you need not worry if the price bounces around in the interim. This leads to three basic facts facing the bond investor: Now, if interest rates rise (the discount factor is higher), then the present value, or price, of the bond will fall. The price of the bond is simply the discounted present value of the fixed interest payments and of the face value of the loan payable at maturity. But, as indicated above, interest rates do change from year to year in response to changes in economic conditions, inflation, monetary policy, and so on. Thus, if a one-thousand-dollar twenty-year bond has a fifty-dollar-per-year interest (coupon) payment, that payment never changes. (By 1980 bonds with actual coupons had virtually disappeared.) The coupon payment is fixed for the life of the bond. The interest payments on the bond are often referred to as “coupon” payments because up through the 1950s, most bond investors actually clipped interest coupons from the bonds and presented them to their banks for payment. When you invest in a bond, you are lending money to the issuer. A bond is simply a long-term IOU issued by a government, a corporation, or some other entity. ![]() Most long-term loans are made via bond instruments. ![]()
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