I started casually reading Schweser fixed income section and came across market value risk for bond investing it stated if i remember correctly (at work dont have the book) a Risk averse investor should invest in Short term maturity as oppose to long term maturity bonds as longer term maturity yields are more volatile.
I always thought Long term Yields are less volatile then shorterm maturity yields can someone be kind enough to explain this.
Market value risk is simply the risk of movements in market prices. Since the duration of a longer term security is higher (obviously), movements in underlying yields have a larger impact on market prices, making them more volatile. You know this though because you’re a level III candidate.
I’m not sure if short rates or long rates are substantially more volatile over the long run (I can tell you long rates have been more volatile in recent history). But the impact on longer term securities of any change in yield is much more profound and therefore an investor adverse to market risk (movements in market price) would prefer shorter term securities.
Thank you for your reply it makes more sense now, if a bond investor in invested in a bond with 20 year maturity and has a coupon of say 5 % if market rates go up to 7 % he will be more effected then someone who is invested for 2 years at that rate…therefore a risk averse investor would be more inclined to go into shorter duration bonds …
Is that the right way to be thinking why long term bond durations are more volatile then short term bonds?
If you recall your Level I Fixed Income (though this may depend on how long ago you passed Level I), a lot depends on the relative volatility of interest rates (as mentioned by geo, above). Certainly longer-maturity bonds have longer durations than shorter-maturity bonds – hence, greater interest-rate sensitivity – but if short-term interest rates are substantially more volatile than long-term interest rates, the price volatility of short-term (short-duration) bonds may be higher than that of long-term (long-duration) bonds.
If short-term rates are very volatile and long-term rates are very stable, the short-term bonds could be riskier _ despite _ having lower interest-rate sensitivity: two years times 100bp = -2% drop; 10 years times 0bp = 0% drop.
The point is that a risk averse investor is no capable to predict the future yield curve or interest rates. For example if I but a 10 yr and 4 yrs bond, how the interest rates move in future will never with determination be known at the beginning. So, the risk averse investor has only one handle to move ie the Duration selection in his purchases.
Taking this background the long duration bond will be the most impacted.
For instance- post fed tapering news, Indian Interest rates for ST were drastically increased by the regulator. So, only 0-1 yr int rate were moved up the max as in your example above. But you see the results - it was the LT bonds and not ST that moved the maximum.
That is one point, but it is not _ the only _ point.
If an investor (risk averse or not) can predict (or estimate, or whatever) the volatility of interest rates at various points along the yield curve, it makes sense to include those volatility predictions (or estimations, or whatever) in their risk assessment, and make their investments accordingly.