Answer to Question #171998 in Economics for Theo

Question

 Often, the yield to maturity on a debt security will not be equal to the rate of return on that same security. For this question, assume that you are the proud new owner of a 30-year Treasury bond that has a 5% yield to maturity. Shortly after purchasing the security interest rates unexpectedly rise across the economy. Will this result in your rate of return being higher than, or lower than, the yield to maturity on your bond? Explain how changing interest rates can lead to higher or lower rates of return on long-term debt securities. The answer to this question may include but need not include an equation for the rate of return on a debt security.

Answer 1

Investors holding long term bonds are subject to a greater degree of interest rate risk than those holding shorter term bonds. This means that if interest rates change by, say 1%, long term bonds will see a greater change to their price - rising when rates fall, and falling when rates rise.