In the form of a higher interest rate, a premium is offered by a long-term bond, in order to compensate for the higher risk that the investor had to take because of the higher maturity. The maturity risk premium that a financial instrument offers will be higher, if the maturity of a financial instrument is higher. This is the main reason why, compared to short-term securities, long-term securities generally have more interest rates. In determining the price of a bond, this risk premium plays a significant role.
A bond losing its value before maturity is one of the biggest risks of investing in a long-term bond. You basically are lending or investing money to the issuer when you purchase a bond. In return, at a pre-defined frequency, the issuer is obligated to make regular interest payments, and they have to pay the principal payment at maturity. For example – you will get your money back at the end of two years if you have invested in a two-year bond. But in other cases, assume you have invested in 25-year bond, then you will have to wait for twenty-five years to get the money back. There is not a lot of chance that many anything could drastically change in 2 years, but in 25 years, there is a high change of something changing. These changes if they occur could be major and various, and they may have a severe impact on the payment status of the interest and the principal of the bonds.
Changes could be something like the issuer running into financial hardships during that time period. Th bond issuer might not be able to make the payments of interest at regular intervals if this is that case, they may not even be able to pay back the principal amount on maturity, or worse, both. Moreover, there could be a fall in the bond’s intrinsic value if the market interest rate goes up known as interest rate risk, this as you guessed is a massive risk. There are reinvestment risks as well, that are involved in security with longer maturity. This the risk of cash flows that the investor can get over the life of the bond, and cannot be reinvested at a higher interest rate. All these are the reasons for investors why long-term bonds needing an extra incentive. Maturity risk premium is what this extra incentive comes in the form of.
Between the concept of maturity risk premium and interest risk rate, there is a very close connection. The principal maturity and the set rate of interest payment is to be undertaken by the issuer if you invest in a bond. There are chances hat he market rates can rise before the maturity. The bond you invested in, in such cases, gives you interest rate at a lower than market rate. If you have any issues or queries that you want to clear, please do not hesitate to ask us. You can find experts here who are ready to answer your queries