Long-Term Bonds and Short-Term Bonds: Interest Rate Risk
Updated on 23 Feb 2020
One of the worries investors have is that changes in interest rates might affect the value of their bond investments. In this article, we talk about the correlation between interest-rate risk and bonds.
A bond is a fixed income investment or debt security. Here the investor loans money to an entity that can be either a corporate organization or the government. The issuer of the bond provides the funds for a fixed period. A particular investor’s portfolio will consist of three basic types of bonds based on the average maturities of the bonds:
- Short-term-less than 5 years
- Intermediate-5 to 10 years term
- Long-term-more than 10 years term
Depending upon their tenure and market conditions, Short-term bonds have low risk and low yields, while longer-term bonds offer higher yields and also greater risk. Intermediate-term bonds fall in the middle of these two categories as far as risk and yields are concerned.
What are long term bonds?
The bonds which are offered for a long period, typically equal to 10 or more years, come under the category of Long-Term bonds. Long term bonds offer greater yields over time, but at the same time offer more risk potential.
What are short term bonds?
The bonds which are offered for a short time, typically for a tenure below five years, come under the category of Short-Term bonds. Short term bonds offer lesser yields in their tenure, but at the same time offer less risk potential.
What is the relationship between risk and yield, in the case of bonds?
Bond investment is based on ‘interest rate risk’. The market interest rates and the bond prices generally move in opposite directions. Simply put, when market interest rates rise, prices of fixed-rate bonds fall. Similarly, when the interest rate decreases, bond prices in the market increase. This is the phenomenon of interest rate risk.
For example, let us take a case where a treasury bond offers a 3% interest rate, and a year later market interest rates fall to 2%. The bond will still pay a 3% interest rate. This is still better than the new bonds paying just a 2% interest rate. If you sell this 3% bond before its maturity date, you will find its price higher than it was a year ago.
With lower market interest rates, the bond prices for fixed-rate bonds becomes higher, and at the same time, the yields become lower.
What is the interest rate risk in the case of long-term bonds?
In the case of buying a longer-term bond, the investors’ money is locked up for a longer period which gives more time for interest rate movements. This can greatly impact the bond’s price. Bonds with maturities of more than a year are subject to price fluctuations. This can lead to interest rate risks. The longer the time until maturity, the larger is the price fluctuations.The performance of longer-term bonds is influenced by market forces.
What is the interest rate risk in the case of short-term bonds?
When an investor buys a short-term bond, whose maturity period is within 5 years, the investors’ money is invested for a short period which does not provide enough time for any interest rate fluctuations. The bond price, therefore, does not get impacted much. In other words, the shorter the time until maturity, the lower is the price fluctuation.
Government policies influence the yields in case of short-term bonds.
How to invest in bonds based upon interest rate risks?
Bonds form an important part of your investment portfolio. All bonds are not equal in the opportunities that they provide. The investors, therefore, need some strategies for investing in bonds, so that they can build up the right bond allocation.
Bonds provide regular income to investors. Their prices generally don’t fluctuate too much relative to stocks. This ensures a more stable income. Investors generally invest in bonds based upon the risk factor involved and the time of maturity.
An investor for whom safety is the top priority would like to invest in short-term bonds. These short-term bonds provide some yield in exchange for greater stability and lower risk of loss. This suits the requirements for a safe investor.
On the other hand, investors who can tolerate higher risk and are willing to invest their principal sums for more time can invest in long-term bonds. They can take on more risk in exchange for the higher yields in the case of these long term bonds.
Similarly, an investor who has the urgency to use the principal within three years or less should go for the less volatile short-term bonds.Investors must examine high-yield bonds carefully before investment to reduce interest rate risks. They can reduce the risks in two ways:
- You can buy a bond exchange-traded fund diversified by the issuer, to reduce the risk of an issuer not paying back a bond. This protects any one issuer.
- You can buy a bond ETF diversified by maturity, to reduce the risk of rising interest rates. This helps to limit the damage or risk caused by rising rates on your bonds.
You can develop a mixed bag portfolio by buying some short-term bonds, some medium-term bonds, and some long-term bonds. This will reduce your overall interest rate risk and tend to provide a stable portfolio. For more queries, do let us know at email@example.com.
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