The longer the length of time from the date a bond is issued until its
maturity date,
the more sensitive it will be to interest-rate changes. So, when interest rates are rising, a 10-year note issued before
the rate increase will drop in price more than a 2-year note. And when interest rates are falling, a longer-term bond issued at the earlier higher rate may rise in price more than a shorter-term bond.
The reason longer-term bonds are more affected by interest-rate changes is because they lock the investor's money in at the bond's
coupon rate
for a longer period of time. For instance, if inflation or interest rates — which generally move in tandem — rise, the interest an older bond
pays may not keep pace with rising costs or with the higher interest rates provided by newly issued bonds. Plus, the price of the bond
falls on the secondary market because buyers are unwilling to pay full price for an older bond paying a lower interest rate when newer bonds paying higher rates are available.
You can curtail some of the
interest-rate risk
of investing in individual bonds by holding your bonds until
maturity
rather than reselling them. You'll continue to earn interest at the rate you anticipated, and you'll get back the full
face value
of the bond when you
redeem
it. Of course, there's no guarantee that the interest that the bond pays
will keep pace with the interest rate paid by newer issues, or with
inflation.
Inflation, not the Fed The
Federal Reserve
has no direct control over the interest rates bonds pay. Interest rates on Treasurys are set by auction, while corporate bond rates are set by the investment bankers who
underwrite
the bonds. Many experts point out that bond interest rates move in response to expectations about
inflation rather than directly in response to Fed rate changes. One of the Fed's main tools in curbing inflation is to raise the federal funds rate — the interest rate at which banks borrow from each other. When the federal funds rate goes up, bond coupon rates
tend to rise as well in anticipation of higher inflation.
