the longer the time to maturity: the greater the price increase from an increase in interst rates; the less the price increase from an increase in interest rates; the greater price increase from a decrease in interest rates; the less the price decrease fron a decrease in interest rates
To determine the impact of changes in interest rates on bond prices with different time to maturities, you need to understand the concept of bond price sensitivity, which is measured by a metric called duration.
Duration is a measure of how sensitive a bond's price is to changes in interest rates. It takes into account both the time to maturity and the bond's coupon rate. Generally, the longer the time to maturity, the higher the duration.
Now, let's examine the relationship between changes in interest rates and bond prices with different time to maturities:
1. Longer Time to Maturity, Increase in Interest Rates:
When interest rates increase, bonds with longer time to maturity will experience a greater decrease in price compared to bonds with shorter time to maturity. This is because the longer the bond's duration, the more sensitive it is to changes in interest rates. Investors demand higher yields to compensate for the longer period of time their money will be tied up in the bond.
2. Longer Time to Maturity, Decrease in Interest Rates:
If interest rates decrease, bonds with longer time to maturity will experience a greater increase in price compared to bonds with shorter time to maturity. Again, due to their higher duration, these bonds are more sensitive to changes in interest rates, resulting in a larger price increase.
3. Shorter Time to Maturity, Increase in Interest Rates:
When interest rates increase, bonds with shorter time to maturity will have a smaller decrease in price compared to bonds with longer time to maturity. This is because the shorter the time to maturity, the lower the duration, and thus, the lower the price sensitivity to changes in interest rates.
4. Shorter Time to Maturity, Decrease in Interest Rates:
If interest rates decrease, bonds with shorter time to maturity will have a smaller increase in price compared to bonds with longer time to maturity. With their lower duration, these bonds are less sensitive to changes in interest rates, resulting in a smaller price increase.
In summary, the impact of changes in interest rates on bond prices depends on the duration, which is influenced by the time to maturity. Bonds with longer time to maturity have higher durations, making them more sensitive to interest rate changes. Therefore, they experience greater price increases when interest rates decrease but larger price decreases when interest rates increase. The opposite is true for bonds with shorter time to maturity.