Bond Return as a Function of Maturity Date
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?
Normal Yield Curve
Inverted Yield Curve
Flattening of the Yield Curve
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.