Maturity risk is another factor that affects interest rates. It refers to the risk that the value of a security will change due to fluctuations in interest rates over time, particularly when the security has a longer maturity date.
For example, consider a bond that has a 10-year maturity and a fixed interest rate of 5%. If interest rates in the economy increase to 6%, then newly issued bonds with a 6% interest rate become more attractive to investors, as they offer a higher return than the previously issued bond. As a result, the demand for the 5% bond decreases, and its price drops, since investors can obtain a higher return by investing in the new bond. This decrease in price means that the bondholder may lose money if they need to sell the bond before it reaches maturity.
On the other hand, if interest rates in the economy decrease to 4%, then the fixed 5% interest rate on the bond becomes more attractive to investors, as it offers a higher return than newly issued bonds with lower interest rates. The demand for the 5% bond increases, and its price rises, as investors are willing to pay more to obtain the higher return offered by the bond.
Thus, the longer the maturity of a security, the greater the sensitivity of its price to changes in interest rates, which means that longer-term securities carry more maturity risk. This risk is reflected in the interest rate that the security pays, with longer-term securities typically offering a higher interest rate to compensate investors for the added risk of changes in interest rates over time.
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