Interest Rates

Maturity in Debt Securities

Bond Return as a Function of Maturity Date

Investors engage with investments and assess risks based on the value of the bond at maturity because of inflation risk.

The maturity, or term, of a bond is the date at which the full amount of the bond, plus interest, will be paid. A $1,000 10-year bond with 10 percent interest would pay 10 percent of $1,000 every year for nine years and $1,000 plus 10 percent of $1,000 on the last year. Because of the wide range of terms for maturity, this form of risk is the most common that an investor must assess. To understand how interest rates may change based on maturity, it is useful to know the link between Treasury securities and the economy. The U.S. government uses Treasury securities to adjust various aspects of the economy. To force expansion economics, the federal government will buy back securities and lower interest rates. To force contraction, the federal government will issue extra securities, which remove investor capital from circulation, slowing economic growth. In theory, these factors are part of the inflation risk premium.

When comparing government bonds to commercially issued bonds, a company that issues the bond, unlike the government, can change significantly over time. Inflation is an external factor that can affect the company, but maturity risk also includes internal factors such as a change in market segmentation or technologies. Maturity risk then overlaps with inflation risk and default risk. Default risk is the level of risk investors and lenders may incur if a borrower defaults on a loan. Inflation risk and default risk have their own measures, so maturity risk covers everything else that might affect a company outside of inflation or default. Likewise, it takes into account the time value of money, because the money invested would be money that is no longer available to the investor. It is a comprehensive risk premium to incentivize investors to wait longer to receive payments.

Like the other risk premiums, calculating the maturity risk premium starts with comparing the bond to a risk-free security of the same maturity. The maturity risk premium is the extra premium an investor receives from engaging with investments that have a longer duration until maturity. If all other risk premiums are removed, the difference between the market rate and the risk-free rate is the maturity risk premium.

What Is a Yield Curve?

The yield curve is a graphical representation of risk and return and reflects economic depression, expansion, and flat economic growth.
A yield curve is a graphical representation showing the interest rates of securities with similar risk and maturity. During times of economic expansion, investors will expect to earn higher returns for longer periods of time. The yield curve will be normal or will slope upward, starting at a lower interest rate and increasing over time.

Normal Yield Curve

The upward-sloping, or normal, yield curve occurs when the investor expects a greater return for bonds with a longer maturity. The return rate is the interest rate on the bond.
During a recession, the yield curve will be inverted, or slope downward.

Inverted Yield Curve

The inverted, or downward-sloping, yield curve is typical during times of recession. As the government adjusts for recession, the investor expects less return over time.
A yield curve that is flat is a result of an economy that is shifting from expansion to contraction or from contraction to expansion.

Flattening of the Yield Curve

The nonrecession year line shows the upward slope associated with the expanding economy. As a recession hits, the recession year line flattens.
Because Treasury securities are so closely linked to general economics, there are varying theories associated with which term structure of interest rate is best and the predicted outcomes of each. Term structure of interest rate is the relationship between nominal interest rates and the time to maturity of comparable quality securities. Nominal interest rate is the interest rate before inflation is considered. According to the expectations theory, the shape of the yield curve is a result of the investor's expectation for return. Expectations theory is the belief that future expected short-term interest rates are based on current expectations of long-term interest rates. If the investor expects less of a return in the future, the yield curve will slope downward. Because the investor has preconceived expectations, this theory assumes that the maturity risk premium is zero, letting the inflation premium and the return rate generate the income. The maturity risk premium is the extra premium an investor receives for pursuing investments that have a longer duration until maturity.

According to the liquidity preference theory, investors require a higher premium on medium- and long-term investments versus short-term investments to offset investors' desire for greater liquidity. Because securities are backed by debt, borrowers want long loan terms so they have more time to pay, but this increases the risk of default. Liquidity corresponds to low maturity terms and lower return rates. The market segmentation theory states that securities with long-term and short-term interest rates are not interchangeable. For example, asset-backed securities from commercial banks are different from those of insurance companies. The commercial bank's securities have a significantly higher default risk than those associated with insurance annuities.