Short Term Vs Long Term Bonds

Short term vs Long term bonds

Long term bonds are most sensitive to interest rate changes. The reason lies in the fixed-income nature of bonds: when an investor purchases a corporate bond, for instance, they are actually purchasing a portion of a company's debt. This debt is issued with specific details regarding periodic coupon payments, the principal amount of the debt and the time period until the bond's maturity.

Here, we detail why it is that bonds with longer maturities expose investors to greater interest rate risk than short-term bonds.

KEY TAKEAWAYS

• When interest rates rise, bond prices fall (and vice-versa), with long-maturity bonds most sensitive to rate changes.
• This is because longer-term bonds have a greater duration than short-term bonds that are closer to maturity and have fewer coupon payments remaining.
• Long-term bonds are also exposed to a greater probability that interest rates will change over its remaining duration.
• Investors can hedge interest rate risk through diversification or the use of interest rate derivatives.

Interest Rates and Duration

A concept that is important for understanding interest rate risk in bonds is that bond prices are inversely related to interest rates. When interest rates go up, bond prices go down, and vice versa.

There are two primary reasons why long-term bonds are subject to greater interest rate risk than short-term bonds:

1. There is a greater probability that interest rates will rise (and thus negatively affect a bond's market price) within a longer time period than within a shorter period.