People who place their money in safe investments have a number of options. Fixed investments do not have own an ownership interest like equity investments (like stocks) but can have a more stable return.
Bonds can be issued by governments and corporations. The strength of the organization backing the bond helps to determine what the interest rate will be, but the maturity, or how long the bond is issued for, also plays a factor.
Lengths of Maturity for Bonds
Bonds can be classified into different groups based on when they mature, based on the date of issuance:
- Short Term
- Intermediate
- Long Term.
There is no industry standard for each category, but short term is usually considered from 1 to 5 years, intermediate from 6 to 19, and bonds with a maturity over 20 years into the future are considered long term.
For example a bond issued January 11, 2011 that matures on January 11, 2041 (30 years) would be considered long term. Maturity means that the bond principal is paid back to the person holding the bond, and interest payments will cease.
Differences Between Short Term and Long Term Bonds
Generally, interest rates on long term bonds are higher than short term. This is because a bondholder takes on more risk the longer he holds the bond. There is the risk that the company will default on the bond, as well as the risk that interest rates will change substantially over the life of the bond.
In some unusual cases, longer term bonds will carry lower interest rates than short term. This situation is called an inverted yield curve, because a graph of the interest rates over time is the opposite of the normal situation.
An example of a normal situation would be that interest rates on a 5 year bond would be 2%, but in order for a company to keep the money for 30 years, they would have to offer 4%. Investors would then have the option of purchasing the short term, or rolling the dice on a longer term bond.
If market interest rates go up to 6% in five years, it would have been better to have bought the short term bond, since after five years; it would be possible to invest at 6%, rather than being locked into the 4% rate. Of course, investors don’t know what the future holds, and they need to make their best guess when the option presents itself.
Short Term and Long Term Bond Funds
Similarly, bond funds, that is, groups of bonds available for investment as a basket, are impacted by changes in interest rates. A fund that invests in short term bonds will see less fluctuation than a long term bond fund if interest rates change.
In periods of low interest rates, buying a short term fund will usually result in lower yields, but there will be less chance of a major drop in the value of the fund. Long term funds can generate higher interest payments, but if market rates jump, the value of the funds will drop. Global bond funds are also subject to currentcy risk.
Investing in short term bonds generally means accepting a lower yield, but reduces risk. Investors chasing higher interest rates in long term bonds may regret that decision if interest rates skyrocket.
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