When bond investors take more of a risk, the market compensates them with a higher return. If it didn’t, they would tend to buy a safer bond. So the main reason longer dated bond yields are higher than yields on shorter dated bonds is because longer dated bonds are riskier.
The price of bonds rises and falls with interest rates. When interest rates go up, the value of bonds goes down. If a government bond pays 9 percent when it is issued (you wish!), it pays out $90 a year for each $1,000 bond. However, what if new bonds are issued that pay 10 percent? The new bond would pay out $100 each year for a $1,000 bond.
The price of the old 9 percent bond would go down. Other factors affect its price, but in theory, its price would sink to $900. In other words, the value of the 9 percent bond will drop until it yields about 10 percent, and $90 is 10 percent of $900. When the bond reaches maturity, the investor will still be paid back his or her $1,000, but meanwhile the bond is worth less, because it pays less.
Long-term bonds drop more, because an investor is stuck with an inferior payout for a longer period. A debt instrument that will mature in one year or less, though, is essentially unaffected by an interest rate change, because the investor is about to be paid back. A twenty year bond, however, will pay less interest than the new bond for nineteen more years. It is the risk of this drop in value caused by a rise in interest rates that causes the long bond to pay more interest.
Incidentally, a drop in interest rates would cause the value of an old bond to rise. Old bonds that pay more interest than current bonds sell at a premium, that is, at higher prices than they originally cost.
There are other factors that make longer dated bonds risky. Inflation damages the value of bonds, because the interest they pay out stays the same, while the prices of things that the interest will buy rise. A longer bond has more time to lose value through inflation.
On the other hand, in deflation, as occurred during the Great Depression, the value of a bond would rise instead. However, inflation has been a fact of life for some time now, and this fact is reflected in the yield of long bonds.
Longer term bonds are also riskier because there is more time for something to happen to the issuer. The U.S. government is good for its bonds, because it has the power to tax, but some corporations might not be around in ten or twenty years. So investors demand higher yields to compensate them for this long term risk of some unforeseen event.
Even sturdy companies pay higher interest to compensate for being riskier than government bonds. They issue corporate bonds, and they pay more interest than the government. New or apparently unstable corporations can pay quite a bit more.
However, when corporations borrow for very brief periods of time, the market considers that it is unlikely that anything will go wrong so soon. Short term interest rates for corporate borrowers are therefore lower than those on their longer term bonds, just as short term government yields are lower.
The yield curve
It is possible to chart the interest rates of bonds. When the yields of bonds of different maturity dates are plotted on a graph, the result is called a yield curve. Normally, the yield curve slopes upward, because shorter dated bonds pay less interest than longer maturities.
However, in some circumstances, longer dated bonds can pay less than current bonds. Investors may anticipate deflation. They may expect high unemployment in the future. The Federal Reserve Board can attempt to change the shape of the curve. Many things can cause the yield curve to invert, but generally an inverted curve is taken as a warning that investors anticipate a recession. That does not mean one will come.
Normally, though, longer dated bonds pay more, because they are more vulnerable to changes in interest rates. Inflation can have a stronger effect on long bonds’ value, and there is more time for something to happen that will cause an investor to lose money.
Investors must consider all these factors and balance their portfolios. Many investors end up with a mix of different maturities, sometimes arranged as a bond ladder of regularly spaced repayments. There is safety in shorter bonds, but seductively higher income in longer dated bond yields.