For investors, the choice of which bond to buy can be tricky.
Bond investors face a big choice when they have money to invest: Should they pick long-term bonds or short-term bonds for their portfolios? Both types of bonds have advantages and disadvantages, so there's no one right answer for everyone. Instead, you have to look at the pros and cons of both long- and short-term bonds to see if the rewards outweigh the potential problems.
Short-term bonds
Short-term bonds are attractive to many investors because they don't require you to tie up your money for long periods of time. They're suitable for those who will need to spend their invested money in the near future, but they can also be useful even for long-term investors. For instance, if you expect a rise in interest rates over the short run, then investing in a short-term bond will let you reinvest the money at maturity in a bond that by then should be paying a much higher interest rate.
The downside of short-term bonds is that they generally pay lower interest rates than long-term bonds. As a result, in order to get the benefits of a short-term bond, you typically earn less income, forcing you to make sure that the advantages short-term bond investing brings are truly worth it for you.
Long-term bonds
Long-term bonds have much different attributes from short-term bonds. With a long-term bond, you'll typically earn a higher interest rate, as the entities that issue the bonds will be willing to pay more in interest in exchange for the security of locking in a known rate for a longer period of time. If you need to maximize income, then a long-term bond can look extremely attractive.
The downside of long-term bonds is that you lack the flexibility that a short-term bond offers. If interest rates rise, for instance, the value of a long-term bond will usually go down, penalizing you for having committed to a locked-in rate for the long haul. In addition, depending on the issuer, a long-term bond can have a greater risk of default -- especially if the same issuer has other outstanding bonds that mature before the bonds you own.
Solving the dilemma
Most investors end up having a mix of short- and long-term bonds in their portfolios in order to get the best of both worlds. Yet the question still remains how much to invest in each kind, and how you answer that will depend on which traits of each type are more attractive to you. Both short- and long-term bonds are suitable investments for most portfolios. Visit our broker center to set up an investing account and buy either -- or both -- today.
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FAQs
Typically, short-term bonds offer much smaller yields but are considered less risky, so they're at the lower left-hand side of the graph. Longer-term bonds generally provide larger yields because the uncertainty about future events makes them riskier. They're usually in the upper right-hand side of the graph.
What is the difference between long-term and short-term bonds? ›
Long-term bonds have a greater duration than short-term bonds. Duration measures the sensitivity of a bond's price to changes in interest rates. For instance, a bond with a duration of 2.0 years will decrease by 2% for every 1% increase in rates.
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What are the 3 major disadvantages in using bonds for long-term financing? ›
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
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Since launching in 2002, the Motley Fool Stock Advisor has delivered an average stock return of 644%*, significantly outperforming the S&P 500's 149% return in the same timeframe.
What are the cons of long term bonds? ›
The downside of long-term bonds is that you lack the flexibility that a short-term bond offers. If interest rates rise, for instance, the value of a long-term bond will usually go down, penalizing you for having committed to a locked-in rate for the long haul.
Are short term bonds more risky than long term? ›
Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do. Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier.
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Why is a bond not a good investment? ›
There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall.
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
Why not invest in bonds? ›
All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.
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What is a good return on investment over 5 years? ›
General ROI: A positive ROI is generally considered good, with a normal ROI of 5-7% often seen as a reasonable expectation. However, a strong general ROI is something greater than 10%. Return on Stocks: On average, a ROI of 7% after inflation is often considered good, based on the historical returns of the market.
What is considered a long term bond? ›
Long bonds offer a maturity date far out on the investment horizon. For the U.S. Treasury market, this includes the 30-year Treasury which has the longest maturity of all offerings. Corporate bonds, however, can issue maturities in different variations. Corporate bonds may offer maturities of 15, 20, or 25 years.
What is considered a short term bond? ›
Short-term bonds are fixed-income securities with relatively short maturities, generally defined as about one to three years. These bonds are less sensitive to changes in interest rates than bonds with longer maturity dates.
Why are short term bonds better? ›
Short-term bonds can be relatively predictable, low-risk income. Stronger returns can be realized when compared to money markets. Some bonds even come tax-free. A short-term bond offers a higher potential yield than money market funds.
Are short term bonds better? ›
Bonds with shorter times to maturity are less sensitive to changes in interest rates than longer-term bonds, meaning investors won't suffer as much if rates head higher. Remember, interest rates and bond prices move in opposite directions, so as rates rise, bond prices fall and vice versa.
