One of the dangers of investing in a long-term bond is the potential for it to lose value before it comes due. When you buy a bond, you're essentially lending an entity (such as a company or municipality) money in exchange for regular interest payments. The bond issuer is obligated to pay you interest until your bond matures, at which point the issuer must return your principal as well.
If you invest in a bond with a two-year maturity date, then you'll get your principal back in two years if all goes according to plan. On the other hand, if you invest in a 30-year bond, you'll need to wait 30 years before your principal is repaid. Because a lot can happen over the course of 30 years, investing in a 30-year bond is riskier than investing in a shorter-term bond, all other things (like credit rating) being equal.
Over the course of many years, a company or municipality can run into financial troubles, for example, increasing the risk that your principal will not be repaid fully -- or at all. Additionally, when you invest in a long-term bond, you're taking on what's known as "interest rate risk." Over time, there's a good chance that interest rates will rise, and when that happens, bond values tend to fall. For this reason, investors need added incentives to purchase long-term bonds.
This is where maturity risk premiums come into play.
A maturity risk premium is the amount of extra return you'll see on your investment by purchasing a bond with a longer maturity date. Maturity risk premiums are designed to compensate investors for taking on the risk of holding bonds over a lengthy period of time. Generally speaking, the longer the time until maturity, the higher the maturity risk premium.
Calculating maturity risk premium
To figure out the maturity risk premium for your investment, you'll start by identifying the bond you wish to purchase and the maturity date it comes with. For our purposes, let's assume you wish to purchase a 10-year bond.
Next, you'll need to find the yield for risk-free securities with the same duration as the bond you're looking to buy. Treasury securities are considered risk-free because they're backed by the U.S. government. From there, you'll need to find and subtract the rate of the one-year Treasury bill from that of the 10-year Treasury bond. This represents the minimum risk premium for buying a bond with a 10-year maturity.
Let's say the current yield on a one-year Treasury bill is 0.51%, and the current yield on a 10-year Treasury bond is 1.71%. If we subtract 0.51% from 1.71%, we arrive at 1.2% as a baseline maturity risk premium for 10-year bonds.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.