Long-Term vs. Short-Term Bonds Problems

For investors, the choice of which bond to buy can be tricky.

Jan 17, 2016 at 3:45AM

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.

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