Volatility of bond returns
The Tom example also demonstrates how volatility changes with time to maturity. The most volatile bond is the one stretching for 20 years - its price is very sensitive to market interest rates, there is a large amount of interest rate risk.
The degree of price change is much smaller for the five-year bond and non-existent for the one-year bond (although there would be some impact from market interest rate changes if the one-year bond was sold in a few months rather than after the whole year is out).In general, rates of returns and prices for long-term bonds are more volatile than they are for short-term bonds.
This means that if the investor has a time horizon of only a year or two, long-term bonds may be seen as risky investments - even if they have very low default risk, they have high interest rate risk. It is not uncommon for bonds to lose or gain a significant percentage of their value in a year, even if they are reputable government bonds. This is illustrated in Chapter 1 (Figure 1.3) by the returns on UK gilts for every year going back to 1900. On many occasions an investor who purchased bonds at the beginning of the year and sold at the end lost more than 10%, despite receiving coupons.