Bonds come in many different maturities, and are divided into three nominal groupings: Short term bonds have maturities up to five years. Intermediate term bonds have maturities ranging from five years to 12 years. Long term bonds are those bonds with maturities longer than 12 years. The longest maturity U.S. Treasury issued is 30 years, but some corporate bonds are issued for longer maturities. Each differs in the way it responds to risk.
A lot can happen to change the financial strength of a company. Lawsuits, mismanagement, union strikes, defective products, loss of market share or development of new technology have resulted in lowered credit ratings for previously strong corporations. While bad things can happen in a short amount of time, the longer the maturity on a bond, the greater the chance that something will negatively affect the issuer's credit rating. This is why interest rates on long maturities are higher than interest rates on similar credit-rated intermediate bonds. The higher interest rate makes up for the extra risk implied by the longer maturity.
Interest Rate Risk
Longer maturity bonds fluctuate in dollar price more than intermediate bonds for a given change in market yield rates. Take two imaginary bonds: The intermediate bond has a 5 percent coupon and matures in seven years. The long bond has a 5 percent coupon and matures in 30 years. Both bonds were issued at par, or $1,000 face value. If market yield rates rise to 8 percent, the intermediate bond will be worth $841.73 but the long bond will decline in price to $660.66 because of the length of time to maturity and how it affects the yield-to-maturity calculation. The price fluctuation will be similar, but positive, if interest rates decline. For this reason, when interest rates are expected to rise, professional portfolio managers buy intermediate and short-term maturities. When interest rates are expected to fall, they buy the longest maturities they can, to maximize the profit potential from selling those bonds.
When interest rates are rising, it may be difficult to sell a long bond because investors would rather buy short to intermediate-term paper to avoid a loss in dollar value. When this happens, the market demands higher yields on longer bonds. Generally, buyers of long bonds tend to be insurance companies and pension funds that are buying more for the maturity date than the yield. They are more concerned with having bonds mature on a certain future date when large pension or annuity payments will be made to their customers.
When a company needs money during high interest rate periods, and long bonds are in great demand by investors, the company may issue a long bond regardless of the high interest cost. However, it will have a provision that allows it to call the bond in five, seven or 10 years. When interest rates decline, companies that have issued high-interest-rate bonds will call those bonds at par -- their $1,000 face value -- and issue new bonds at the lower interest rate. The call prices may vary, but the result is always the same: the investor loses ownership of a high-interest-rate bond and the issuing company refinances at a lower interest cost.
- Securities Industry and Financial Markets Association: Key Bond Investment Considerations, Part 2
- Fidelity.com: Evaluating a Bond Fund
- Securities Industry and Financial Markets Association: Key Bond Investment Considerations, Part 1
- "USA Today"; Intermediate Bond Funds Worth a Look; John Waggoner; July 2001