When Should You Invest in Long-Term Bonds?

Jan 01, 2024 By Triston Martin

Interest rate fluctuations have the most significant impact on long-term bonds. This is because bonds are a form of fixed income, meaning that when an investor buys a corporate bond, for example, they are effectively buying a piece of the company's debt.

Coupon payments, the principal amount, and the maturity date are all detailed at the issuance time. Long-term bonds have a higher interest rate risk than their shorter-term counterparts, and we explain why.

Individual Bonds

Bonds have set principle values that are returned at maturity, and they usually make coupon or interest payments every six months. Even though bonds have fixed par values, their secondary market prices might move in response to changes in interest rates.

Bond prices tend to go down whenever interest rates go up, and vice versa. The price of a bond tends to approach its face value as its maturity date nears. A cost associated with keeping a bond to maturity: You might lose out on larger coupon payments given by newer bonds on the market if rates rise while you keep the bond.

Bond Mutual Funds

Bond mutual funds often hold bonds with varying maturities, coupon rates, and credit ratings. Unlike individual bonds, which typically pay interest every six months, bond funds pay out dividends to investors monthly.

These distributions can be cashed out or reinvested in the fund to generate compound interest. There is no assurance that bond fund investors will get back their initial investment at a later date, which is especially important in a rising interest rate environment.

A High-Risk, High-Reward Bet on Long-Term Bond Funds

As can be seen from the returns presented above, long-term bond funds can occasionally provide returns similar to those generated by higher-risk asset classes like small-cap stocks. Whenever bond rates go down, longer-term issues tend to do better.

In 2011, the conditions were ideal for these funds since the yield on the 10-year note fell from 3.31% to 1.87% over the year while its price soared. Therefore, long-term bond funds may be a great trading tool but not the ideal investing option.

Influence of Interest Rate Uncertainty on Bonds

This is known as interest rate risk when there is a change in the general level of interest rates. Fixed-income security prices are sensitive to changes in interest rates. Bond prices tend to decline when interest rates rise because of the potential for loss connected with this increase in interest rates, and the opposite is true when rates decrease.

All bondholders are exposed to interest rate risk since it influences bond pricing. It's been established that bond prices go down as interest rates go up. When interest rates rise, and new bond issues are offered in the market with greater yields than older securities, investors buy the new bond issues to profit from the higher yields.

Investors' Guide to Lowering Interest Rate Risk

Forward contracts, interest rate swaps, and futures are all ways in which investors can mitigate or eliminate their exposure to interest rate fluctuations. For this reason, some investors may choose lower interest rate risk. Investors in bonds, REITs, and other equities in which dividends represent a sizable component of cash flows are more exposed to this danger.

Interest rate risk is one of their top concerns when investors are anxious about inflationary pressures, excessive government expenditure, or a weak currency. The combination of these variables might push inflation and interest rates higher. A decline in value can be expected for fixed-income investments when interest rates rise.

Effects of the Rate Cycle on Long-Term Bond Funds

Potential investors in these products need to keep the entire interest rate cycle in mind. Since 1982, U.S. Treasury rates have been falling steadily; when the Great Recession began in late 2007, the Federal Reserve enacted an interest rate strategy to keep yields low and speed up the economic recovery.

Treasury yields tend to rise whenever there is news that the economy is growing or that the Federal Reserve is about to raise interest rates. As we saw in the second quarter of 2013, when the low interest-rate environment seemed to be ending but did not, it is difficult and maybe impossible to make credible forecasts about when the rate cycle will change.

The Conclusion

Long-term bondholders are more vulnerable to interest rate fluctuations than their shorter-term counterparts. This indicates that the price of long-term bonds will move more dramatically than the interest rate, going up when rates go down and down when rates go up.

Bondholders who keep their investments to maturity are often not too concerned about interest rate risk, as indicated by the more considerable duration measure. More active bond traders can use hedging tactics to mitigate the impact of interest rate fluctuations on portfolio returns.

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