Bond Basics: Short vs. Long Term Bonds

In case you haven’t been paying attention, the mainstream financial media has been all atwitter with talk of a bond bubble. With the recent (and not-so-recent) stock market turmoil that we’ve been dealing with, investors have been flocking to bonds.

The problem with this is that bond interest rates are at historically low levels, meaning that they really only have one way to move – up. And what happens when interest rates move up? That’s right. Bond prices decrease.

Think about it logically… If bonds were paying 3% and rates rose such that new issues were paying 5%, which would you want? The higher one. Thus, the old 3% version will sell at a discount.

If you hold your bonds to maturity, this is a non-issue. But if you: (a) want to sell them early, or (b) own bonds through a bond mutual fund, then you’re facing potential price fluctuations. And again… When rates rise, prices fall.

Of course, this is a bit of an oversimplification, as there are other factors that influence bond price changes. One of the biggest factors is the time to maturity.

In general, longer term bonds are associated with higher interest rates. The primary reason for this is that you are locking your money up for longer, and are taking on more interest rate risk.

Though longer term bonds offer more predictable interest rates, they are subject to much more pronounced price swings. This relationship is summed up very nicely by an interactive graphic that I recently discovered over at Vanguard.

I’ve included a screenshot below, but I highly recommend clicking through and playing with it – especially if you’re not very family with how the bond market works.

And now, a question…

Are we in the midst of a bond bubble? If so, how are you dealing with it?

9 Responses to “Bond Basics: Short vs. Long Term Bonds”

  1. Anonymous

    What the opportunity cost argument misses is the opposite opportunity cost for not taking longer terms with higher rates now. If you can invest in CDs at, say, 1% for a one-year or 2% for a two-year:
    – You take the 2% for two years and have a known return of 4.04%
    – You take the 1% for one year and hope rates go up next year.

    In order to make the same amount, you have to get a rate above 3.01% in the second year. Longer terms make this somewhat less of a factor, but the same argument remains — do you expect rates to go up enough that the delayed investment is still worthwhile?

  2. Anonymous

    We’re in a bond bubble but it may take time to burst. When it does many small investors will once again significantly under-perform the market.
    For the younger generation: you’re going to know what inflation is 5 years from now.
    To protect your portfolio buy CSJ and other short-term fixed income exchange traded funds.

  3. Anonymous

    I disagree with Phillip Brewer. And you will too after viewing some of the information at ShadowStats.com. Inflation data is manipulated. For example, if a steak costs $10 in 1990 and $20 in 2010, inflation would be 100% over that 20 year period, right? Wrong! It used to be like that, but now the government says steak went to $20, so you won’t buy steak – you’ll buy chicken for $10. Therefore, inflation is zero.

  4. Anonymous

    Right! Your US readers might want to check out Series I savings bonds for the same reason.

    They offer a tiny pittance over inflation, but there’s only a 3-month interest penalty if you cash out before 5 years are up. On the other hand, final maturity isn’t for 30 years. The combination gives you huge flexibility.

    If the bond turns out to be a good deal, you can just go on holding it for decades. On the other hand, if you can get a better deal elsewhere, the penalty for cashing out is quite small.

  5. Philip: One thing that I’ve been exploring, and which is probably worthy of a post on its own, has been the use of longer terms CDs with a minimal penalty for breaking early as a hedge against rising rates. If you lock you money into (say) a 5, 7, or 10 year CD with a better rate, and only have to forego 6 months interest if you break it, you can earn more in the short term and still come out ahead of current rates (even after the penalty) if rates move up dramatically and you decide to break the CD to re-invest elsewhere.

    P.S. I agree with pretty much everything else you said, as well. 🙂

  6. Anonymous

    First of all, I’d say that it does matter, even for people who plan to hold their bonds until maturity. Yes, they’ll avoid realizing a capital loss (as long as they don’t end up having to sell anyway, for any of a myriad of reasons), but they’re still losers. At a minimum, they’re losers in an opportunity cost sense—they don’t get to reinvest at the new higher rates. But rising rates are closely associated with inflation, so they’re probably losing spending power as well as market value.

    To answer your main question, though: Yes, I think we are in a bond bubble. Personally, I’ve been lightening up on bond investments and putting money into a money market fund and into short term CDs, which sucks because those instruments pay almost nothing. But I’ve got no doubt that rates will go up eventually.

  7. Anonymous

    I used to believe that we might have a bond bubble that would be bursting soon, but now I’m starting to think that the low yields are here to stay for some time. The Japanese have had record low rates for nearly 20 years (AFAIK) yet they have not seen a bust yet. That’s not to say that one will not come, just that the market can stay solvent longer than us little guys can.

    Personally I think equities are overpriced and you’re better off with bonds and cash. The yields are low, but return OF investment is more important than return ON investment.

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