When to Buy Short-Term and Long-Term Bonds

When to Buy Short-Term and Long-Term Bonds?

 

If you are looking for safe investments, you can try investing in bonds, as they offer capital protection. Along with capital protection, bonds also help you earn a return on your invested capital.

 

The return you earn by investing in bonds is known as the yield. Among other things, your yield may differ based on the maturity period of the bond. This relationship between yield and maturity term is represented by the yield curve.

 

In this article, you will learn about short-term bonds and long-term bonds and when you can buy them.

 

But before that, it is important to understand the yield curve and how it behaves in different economic situations.

 

What you need to know about the yield curve

 

A yield curve is a graphical representation where the yield or the interest rate is on the X-axis, and the maturity term is on the Y-axis. Simply put, the yield curve shows the return you will earn if you invest in a bond for a given period. Since the bond yield and maturity term are positively related, the yield curve is upward-sloping.

 

However, the yield curve's shape can change according to market forces and the prevailing economic situation.

 

Broadly, there are three types of yield curves. Let's explore them in detail:

 

1.   Normal Yield Curve: The normal yield curve has an upward slope. It follows the simple rationale that if you invest in a long-term bond, you expect a relatively higher interest. Long-term bonds carry more risks, such as a potential rise in inflation or interest rates. These risks will impact your investment, for which you need to be compensated.

 

2.   Inverted Yield Curve: The yield curve takes an inverted shape when yields on long-term bonds are lower than on short-term bonds.

 

This happens due to two factors:

 

a.   When long bond investors anticipate the future rate of interest to decline, they buy more long-term bonds, causing their price to rise. As you know, bond prices are inversely related to yield,the long term bond yield declines.

b.   When investors sell their short-term bond holdings to buy more long-term bonds, the price of short-term bonds falls, resulting in an increase in their yield.

 

3.   Flat Yield Curve: We see a flat yield curve when the shape of the yield curve changes from normal to inverted or vice versa. It is a transitional period where yields from long-term and short-term bonds are similar. In this situation, investors have no incentive to take on more risk and buy long-term bonds.

 

With an understanding of the yield curve and its types, we can now examine the different economic situations, such as inflation, economic growth, and recession, that impact the yield curve.

 

Let's analyse each of these three situations briefly:

 

1.   Inflation: An increase in inflation negatively affects the present value of all future cash flows (or returns) from bond investments, thus reducing the total income for the investor. To compensate for this loss in income, bond issuers offer higher yields on long-term bonds. Hence, an increase in inflation signals a rise in the future rate of interest.

 

2.   Economic Growth: Economic growth refers to a rise in overall economic activity. In such a situation, more and more capital is required to fuel economic growth. This leads to higher competition for available capital. Bond investors have more options. This leads to an increase in yield.

 

3.   Recession: A recession is when economic activities fall, leading to a loss in production and employment. With a bleak future in sight, investors generally prefer investing in long-term government bonds with almost no default risk. This leads to a rise in demand and a fall in the price of government bonds. Since bond price and yield are inversely related, the bond yield falls in a recession.

 

Short-term and long-term bonds

 

Usually, a bond with a maturity period of five years or less is considered short-term, and a bond with a maturity period of more than five years is long-term.

 

Now that we have discussed various economic situations and their impact on bond yields, we can finally determine when to buy short-term or long-term bonds.

 

Buying long-term bonds in a falling interest rate scenario

 

Interest rate and maturity term are two of the most important factors for a bond investor. This determines the total return on their investment. When the interest rates fall, the bond prices rise in general. However, due to their longer maturity terms, long-term bond yields are relatively higher. So, you may consider buying long-term bonds.

 

Buying short-term bonds in a rising interest rate scenario

 

When interest rates rise, short-term bonds can be more attractive as they carry relatively less risk. This causes the bond price to fall, making short-term bonds with fewer payments less susceptible.

 

To summarise

 

Bonds are a great investment vehicle to prevent capital losses. While bonds issued by the government carry little to no default risk, corporate bonds are low-risk investment options. You can analyse the risk of a bond investment by looking at the yield curve and factors that influence its movement.

 

As an investor, you may buy long-term bonds when you anticipate the interest rate to fall and vice versa. However, the best possible way may be to buy bonds and hold them till maturity.