Bonds are issued by governments and corporations to raise capital. When you buy a bond, you’re essentially lending money to the issuer. In return, the issuer promises to pay you a fixed interest rate over a specific period and then repay the principal amount at maturity.
Bonds are often categorized by their term, or the time between when you buy the bond and when it matures. Understanding the difference between long-term and short-term bonds is an important step to building a strong investment portfolio.
In this article, we’ll break down the key characteristics of short-term and long-term bonds so you can decide which kind is right for your financial goals.
Here’s everything you need to know.
Understanding short-term vs. long-term bonds
Bonds are insured with different maturity dates, or the length of time until you receive the bond’s face value back. Some bond terms span decades, while others last just a few weeks.
Let’s delve deeper into the characteristics of long-term and short-term bonds.
Long-term bonds
Long-term bonds have a maturity of 10-plus years at the minimum. While the U.S. Treasury offers 10- and 30-year bonds, corporate long-term bonds can have various maturities, including 15, 20 or 25 years.
Long-term bonds have a longer duration, which makes them more sensitive to interest rate changes. This means interest rate movements will have a bigger impact on long-term bonds compared to short-term bonds.
So, to make it worth your while, companies and governments usually offer a higher interest rate (yield) on bonds that take a long time to mature. It’s how investors are compensated for the increased risk of holding a bond for an extended period. For example, 30-year Treasury bonds often yield significantly more than five-year Treasury notes.
Short-term bonds
Short-term bonds are debt securities that mature within one to three years. At maturity, the issuer must repay the principal investment (face value) and any accrued interest.
Ultra-short-term bonds (or cash equivalents) have a maturity of less than a year, such as 90-day U.S. Treasury bills. They’re ideal for investors seeking more liquidity. Their returns typically exceed money market accounts but are lower than conventional short-term bonds.
When a short-term bond matures, you receive your principal plus earned interest. Holding a bond to maturity avoids potential losses due to interest rate fluctuations.
Shorter terms generally mean lower risk and lower returns. Compared to a longer-term bond, a short-term bond will typically offer a lower interest rate when all other factors are equal.
Short-term vs. long-term bonds: Key differences
If you’re new to investing in bonds, it’s important to understand the role short-term and long-term bonds can play in your portfolio.
Here are key differences between the two:
- Interest rate sensitivity: Long-term bonds are more sensitive to interest rate fluctuations than short-term bonds. That’s because the longer the maturity, the more time there is for interest rates to change. Short-term bonds, on the other hand, are less affected by interest rate changes due to their shorter maturity.
- Credit risk: Credit risk, or the risk that the issuer will default on the bond, is generally higher for long-term bonds. That’s because there’s a greater chance of unforeseen events impacting the issuer’s ability to repay the debt over a longer time frame.
- Liquidity: Short-term bonds are generally more liquid than long-term bonds, meaning they can be bought or sold more easily. That’s because the market for short-term bonds is more active. Long-term bonds can be less liquid, especially during times of economic uncertainty or market volatility.
- Income generation: Long-term bonds often yield more than short-term bonds because investors require a higher return to compensate for the increased risk.
How to buy short-term and long-term bonds
Bonds are considered part of a well-diversified portfolio. Luckily for investors, you don’t have to research and pick individual bonds to get exposure.
Bond funds offer a simpler and more diversified approach. These are mutual funds or exchange-traded funds (ETFs) that pool your money with other investors’ and invest it in a variety of long-term or short-term bonds. This offers diversification and reduces risk compared to holding just one or two individual bonds.
With a bond fund, you don’t have to worry about managing individual bond maturities. The fund manager handles reinvesting the earnings into new high-rated bonds, so you’re constantly invested and receiving regular income.
Another approach is to create a bond ladder, a strategy in which you invest in bonds with staggered maturities — for example, one, two, three, four and five years. As each bond matures, you reinvest the proceeds into a longer-term bond at the top of the ladder. This helps minimize reinvestment risk without sacrificing too much return today.
Finally, if you’re interested in purchasing individual short-term or long-term U.S. government bonds, you can do so directly at TreasuryDirect.gov.
Short-term vs. long-term bonds: Which is better for you?
During periods of rising interest rates, short-term bonds often outperform long-term bonds in terms of total returns. Conversely, when interest rates are falling, long-term bonds tend to provide stronger total returns.
If you’re seeking a low-risk, stable investment, short-term bonds are a solid option. They’re particularly attractive in rising interest rate environments because they can provide a higher yield without significant price fluctuations. Short-term bonds are a great choice for the cash or fixed-income portion of your portfolio because they offer quick liquidity.
Meanwhile, long-term bonds offer higher potential returns due to their extended maturity. In a falling interest rate environment, long-term bonds are particularly attractive because they lock in higher yields for a lengthier time frame. Given the Federal Reserve’s recent rate cuts, long-term bonds could be appealing to many investors.
Short-term yields are expected to decline faster than long-term yields in the near future, so locking in longer-term bonds might still be a worthwhile strategy.
However, it’s important to note that long-term bond yields have already declined significantly. This means future price increases might be limited.
To manage risk, experts recommend diversifying your bond portfolios by investing in bonds with different maturity dates. This helps balance the potential for interest rate risk, income generation and credit risk.
Bottom line
If you have a long investment horizon and are comfortable with the associated risks, long-term bonds can be a suitable choice. For short-term needs, short-term bonds offer greater flexibility. By understanding the differences between long-term and short-term bonds, you can choose the right type of investment to meet your financial goals and risk tolerance.
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