Long-term vs. Short-term Bonds Problems
Original post by Victoria Duff of Demand Media
Bonds have an image of safety. Buy them and put them away -- they're bonds. They're safe. Bonds are conservative investments, that is true; however, they are subject to interest rate or price risk, credit risk, inflation risk and liquidity risk. If you buy a bond and hold it to maturity, you are safe from most of these risks with the exception of credit risk great enough to cause the issuing company to default on its bonds.
The longer the time to maturity for a bond, the greater the risk that the issuing company will experience financial trouble. It occasionally may be difficult to sell a long-maturity bond because investors may be unwilling to lock in their money at low rates for long maturities during low interest rate periods. This is called liquidity risk. Long maturities have increased interest rate risk because their dollar prices fluctuate more, per a given change in market interest rates, than do the dollar prices of short-maturity bonds, for the same rate change. Further, if you buy a long bond during a high interest rate period to lock in the high yield, the bond will be called away and refinanced at lower rates when interest rates decline -- another form of interest rate risk. Having money in a long bond during times of inflation leaves you with an investment that doesn't keep up with inflation. The increased risk of a long maturity means that the bond must pay a higher yield relative to shorter maturities to make up for the risk and attract investors.
Shorter maturities have less risk, so their interest rates don't have to be as high as long-term maturities to attract buyers. There is less risk that a company's financial health will deteriorate during a 10-year term than during a 30-year term. Their dollar prices fluctuate less per given change in market interest rates than do long bonds. They mature before there is any risk of the bond being called away for refinancing at lower rates. In fact, the main problem with short maturities arises during periods of high interest rates when investors want to lock in the high yields for as long a period of time as possible.
Short maturities are good to buy during transitions from low interest rates to high interest rates. This happens when the Federal Reserve signals its monetary policy will become restrictive to forestall inflation or cool down an overheated economy. At that time, professional portfolio managers slowly shorten the average maturity of their portfolios. This means they sell their long bonds and buy the shortest maturities their investment guidelines allow. As interest rates increase over time, the short maturities will allow reinvestment of matured bonds at increasingly higher interest rates. When interest rates show signs of peaking, or when the Fed signals it will lower interest rates, portfolio managers extend the average maturity of their portfolio by selling the short maturities and buying long maturities, locking in the higher yields for as long as possible.
If you are trying to decide whether to buy a short or long-maturity bond, consider the interest rate outlook. The financial press generally makes it clear what direction interest rates are headed, and reading the latest speeches and announcements by the Federal Reserve Board will help you discern whether to buy short maturities while interest rates are rising, or take a defensive posture against dropping interest rates by allowing your long bonds to increase in value as interest rates decline and then selling them at a profit, investing the money in short-date bonds till interest rates rise again.
- CNN Money: Should I Buy Short-Term or Long-Term Bonds?
- Securities Industry and Financial Markets Association: Key Bond Investment Considerations, Part 1
- Securities Industry and Financial Markets Association: Rising Rates and Your Investments
About the Author
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.