When investing in bonds, it is sometimes tempting to go for longer-term bonds with higher yields. As an investor, you need to be aware of the risks involved with different bond choices. One of those risks is the higher volatility of long-term bonds. The rate vs. volatility trade-off can be a benefit or danger, depending on what happens with interest rates.
Bond Price Function
The price or market value of an investment bond is based on the rate of interest the bond pays -- called the coupon rate -- compared to the current market yield for similar bonds. If a bond's coupon rate is higher than market rates, the value of the bond will be higher than the face amount to bring the yield an investor earns in line with current rates. This is called a premium bond. A discount bond is priced below the face amount, because the bond's coupon rate is lower than current market rates. Bond prices move inversely to interest rate changes.
Factors Affecting Price Volatility
Two features of bonds affect the price volatility in response to changes in market interest rates. A bond with a lower coupon rate will be more volatile than a bond with a higher coupon rate. Also, longer-term bonds are more volatile than bonds with a shorter time to maturity. Volatility in this case is the amount a bond's price changes in response to a specific change in interest rates.
The mathematical concept of bond duration can be used as a measure of the volatility or risk of a bond. Duration is similar to maturity but is a measure of the cash flow of a bond: how long it takes to get back the money invested to purchase the bond. Calculating duration is complicated, but you can get the information from your broker or on the website of a bond fund. The duration number tells you how much the bond price will change for a 1 percent change in interest rates. So a bond with a duration of five years will drop in value by 5 percent if market rates go up 1 percent. A longer-term bond will have a bigger duration number than a short-term bond.
Risks and Gains
The risk of bond volatility depends on which way interest rates are moving. If rates are falling, it is better to own long-term bonds, because higher volatility means higher bond prices. If rates are increasing, you want to own lower volatility, short-term bonds to minimize the price decline in your bond holdings. Bond price volatility does not happen on its own but is always a result of interest rate changes in the bond markets.