This final section brings together the pricing concepts from earlier and applies them to portfolio management decisions. Understanding how maturity and coupon rate affect price behavior helps you evaluate which bonds carry the most interest rate risk and how portfolio managers position for rate changes.
Pull to Par
As a bond approaches its maturity date, its price converges toward par regardless of whether it currently trades at a discount or premium.
- A discount bond's price rises toward par as maturity nears
- A premium bond's price falls toward par as maturity nears
- At maturity, the bond is redeemed at exactly par value ($1,000)
This effect is automatic and predictable. A bond trading at $950 with 10 years to maturity will gradually approach $1,000 as each year passes (assuming no change in credit quality or prevailing rates).
Exam Tip: Gotchas
- Pull to par is automatic. Discount bonds rise toward par, premium bonds fall toward par. This happens regardless of interest rate movements.
Impact of Changing Interest Rates on Different Maturities
Long-term bonds experience larger price swings than short-term bonds when interest rates change.
- A 30-year bond will drop significantly more in price than a 2-year bond when rates rise by the same amount
- This is because the longer the time horizon, the more future cash flows are discounted at the new rate
Portfolio management implications:
- To reduce interest rate risk: Shorten the portfolio's average maturity
- Expecting rates to decline: Extend the portfolio's average maturity to capture the greatest price appreciation
- Expecting rates to rise: Shorten maturities to minimize losses
| Rate Expectation | Strategy | Why |
|---|---|---|
| Rates will fall | Extend maturities (buy long-term) | Longer bonds gain more when rates drop |
| Rates will rise | Shorten maturities (buy short-term) | Shorter bonds lose less when rates rise |
| Rates uncertain | Ladder maturities | Diversifies rate risk across time horizons |
Exam Tip: Gotchas
- Portfolio managers extend maturities when expecting rate declines (to maximize price gains), and shorten maturities when expecting rate increases (to minimize losses). The exam often presents this as a strategy question.
Putting Maturity Strategies to Work
The maturity rules above translate into two practical portfolio techniques.
Laddering
A laddered portfolio spreads holdings across a range of maturities (for example, bonds coming due in 1, 3, 5, 7, and 10 years) instead of concentrating them at a single point.
- A portion of principal matures at regular intervals, giving the investor a steady stream of cash to spend or reinvest at prevailing rates
- It requires no view on rate direction: with holdings across short, intermediate, and long maturities, the portfolio performs reasonably whichever way rates move
- The opposite of a ladder is a bullet, where all bonds mature in a single year. A bullet can earn more yield but concentrates price risk and reinvestment at one date, so it fits an investor with a specific target date rather than one who wants recurring access to principal
Exam Tip: Gotchas
- A ladder needs no forecast. Its purpose is diversification across maturities, not a bet that rates will move a certain way. Concentrating in long maturities to chase appreciation is a directional bet, not a ladder.
Matching Maturities to a Known Cash Need
When an investor must have a specific sum on a known future date (a tuition bill, a home down payment, a balloon payment), buying bonds that mature around that date minimizes price risk for that goal.
- The bond is redeemed at par right when the cash is needed, so interim price swings from changing rates do not matter
- Reaching for a longer maturity to pick up extra yield reintroduces price risk: if rates rise before the date, the investor may be forced to sell at a depressed price to raise the cash on schedule
Impact of Coupon Rate on Price Volatility
The coupon rate also determines how sensitive a bond is to rate changes:
- Low-coupon and zero-coupon bonds are more sensitive to rate changes than high-coupon bonds
- A zero-coupon bond has the highest sensitivity (greatest duration) for any given maturity because all cash flows occur at maturity; there are no intermediate coupon payments to cushion the impact
- High-coupon bonds return more cash flow earlier (through coupons), reducing sensitivity to rate changes
Why low-coupon bonds are more volatile: When a bond pays little or no current income, almost all of the investor's return comes from the final principal payment. That single future payment is heavily affected by changes in the discount rate. A high-coupon bond spreads its returns across many payments, reducing the impact of any single rate change.
Exam Tip: Gotchas
- Zero-coupon bonds have the highest duration for any given maturity. With no coupon payments to return cash early, all of the investor's return is concentrated at maturity, making price maximally sensitive to rate changes.
Putting It Together: The Volatility Spectrum
From most volatile to least volatile:
- Long-term, zero-coupon bond: maximum sensitivity (longest duration, no intermediate cash flows)
- Long-term, low-coupon bond: high sensitivity
- Long-term, high-coupon bond: moderate sensitivity (long maturity, but coupons cushion)
- Short-term, low-coupon bond: low sensitivity
- Short-term, high-coupon bond: minimum sensitivity (shortest duration, most cash flow returned early)
Exam Tip: Gotchas
- Combine both factors when ranking interest rate risk. Longest maturity + lowest coupon = most volatile. A 30-year zero-coupon bond is the most volatile fixed-income instrument. A 1-year Treasury bill is among the least volatile.