It’s key to understand the risk-and-return relationship if you’re thinking of investing in bonds. Look at a few examples to get a better handle on how rates, yields, and risk work together over bond-maturity periods.
What Are Short-Term, Intermediate-Term and Long-Term Bonds?
Short, intermediate and long-term bonds are defined by the bond’s maturity. Bonds are essentially loans from investors to bond issuers. Issuers take the money from investors, pay interest and return the principal after the bond matures. Short-term bonds have maturities of three to four years, while intermediate-term bonds have maturities anywhere between four and 10 years. Bonds with maturities greater than 10 years are long-term bonds.
The Return and Risk Relationship
Understanding bond market risk begins with grasping that there’s a different relationship between risk and yield than there is between risk and average or total return. Risk and yield are related simply because investors demand greater compensation for taking bigger chances. They’ll demand a higher yield when there is high interest rate risk or greater sensitivity to the health of the bond’s issuer, or when there are changes in the economic outlook. You can’t always expect risk and total return to go hand in hand over all time periods. The reason is that bonds are sensitive to changes in interest rates and that sensitivity depends on the bond’s maturity.
How A Bond’s Maturity Impacts Its Interest Rate Sensitivity
Any change in interest rates can impact a bond’s price. When interest rates go up, bond yields rise but pond prices decline. When interest rates go down, bond yields fall and bond prices go up. However, the extent of bond price movement depends the bond’s maturity. Over the long-term, the chances of interest rate fluctuations increase, which means bonds with longer maturities are more at risk of any price chances on that account.
Historical Bond Fund Returns
If we look at the period between 2012 and 2021, there have been multiple cycles of rising and falling interest rates. According to Morningstar analyzed by BlackRock, here’s how different types of bonds behaved in varying interest rate environments. Morningstar’s Core Bond Index includes Morningstar US Government Bond, US Corporate Bond and US Mortgage Bond indexes, implying at least some exposure to long-term bonds. According to Morningstar data, here’s how bond funds performed from the start of the year till mid September.
The Bottom Line
Investors won’t be able to gain the same benefits from owning longer-term bonds as they did from 2008 to 2019 if the bull market in bonds ends, and rates continue to move higher for an extended period. (The Fed has promised that it will.) Assuming similar future performance of bonds and investments based on past performance is never a good idea. Bonds have tended to provide good returns for the last few decades, but they might not always do so.
