2.13  Yield Curve Analysis

Fixed-income securities such as bonds are subject to interest rate risk. Interest rate risk is the risk that when interest rates rise, the price of the bond or preferred stock will decline. This is because investors can purchase bonds with the new higher rates, so previously issued bonds with lower interest rates drop in price in order to remain marketable. Bonds with longer maturities are more vulnerable to interest rate risk than bonds with shorter maturities because there is a greater chance that interest rates will rise over the bond’s life. Thus, bonds with longer maturities tend to pay higher yields than bonds with shorter maturities. This tendency is represented by the normal yield curve depicted in the graph—yield is on the y-axis and length of maturity is on the x-axis.

Assuming that an investor can tolerate some loss of principal and does not need to remove his money in the near future, an optimal strategy is a mix of maturities. Long-term bonds generally provide higher yields, and short-term bonds provide lower interest rate risk, while making some funds available sooner if n