Duration – whether it’s Macaulay duration, effective duration, or any other kind of duration – is a measure of interest rate risk. Some factors affect duration, and therefore affect interest rate risk.
Time to Maturity
Longer maturity bond prices are more sensitive to changes in yields than shorter maturity bonds. As it can be seen from the following graph, the 30-year bond’s price increases a lot more than the 1-year bond in response to a decrease in interest rates.
Bonds with higher coupon rates are less sensitive to changes in interest rates because you can always reinvest the large coupon payments at the prevailing market interest rate. On the other hand, zero coupon bonds are the most sensitive to interest rate swings since all the interest payments of zero coupon bonds are accumulated and paid at maturity.
Bonds with Embedded Options
Putable bonds allow investors to sell the bond back to issuers before maturity at par value and protect them from higher benchmark yields. Therefore, the price of a putable bond is always higher than that of a comparable non-putable bond.
An embedded put option reduces the effective duration of the bond especially when rates are rising. Thus, the inclusion of an embedded option reduces the sensitivity of the price to changes in the benchmark yield curve.
Which of the following bonds would have the most interest rate risk?
A. A 5% coupon bond
B. A 12% coupon bond
C. A zero coupon bond
The correct answer is A.
Smaller coupon bonds are more sensitive to interest rate swings than bonds which pay bigger coupons. Since a zero coupon bond has the smallest of all coupons (being zero), it carries the most interest rate risk.
Reading 54 LOS 54e:
Explain how a bond’s maturity, coupon, and yield level affect its interest rate risk