When it comes to investing in bonds, some of the basic concepts regarding bond risks tend to elude investors. Most understand the risks associated with stocks. If you invest in a stock, and its price increases, you make money, if it drops you lose. But bond risk has many different components. One of those risks is how the interest rate and maturity effect bond prices.
The maturity of a bond is the date on which the principal amount is repaid and the issuing organization returns your investment to you. You can buy bonds with maturities as short as one week or as long as one hundred years. Clearly the maturity (or maturities) you select should be aligned with your investment goals.
As a rule, most investors should consider bonds with maturities of 20 years or less. Many investors stagger the maturities of various bonds in a portfolio to create a “ladder structure”. This creates a blend of short-term and long-term maturities and interest rates.
If you hold a bond to maturity, assuming the bond you own is not in default, you will get back your initial investment. Between now and then, as interest rates fluctuate, the price of the bond will also fluctuate. That means the price of your bond will go up and down.
If interest rates rise, the current value of a bond will drop. If interest rates go down, the current value should rise. The relationship between interest rates and bond prices is inverse. The price of a short-term bond will fluctuate less than that of a long-term bond because the shorter the maturity, the sooner you will receive your principal back and the sooner you can reinvest at current rates. The shorter time frame reduces the risk that something can go wrong. Because there is less risk of price volatility with a short-term bond compared to a long-term bond, the interest rate should be lower on the shorter maturity. Shorter maturity, less risk, less interest. Longer maturity, more risk, higher interest rate.
What length of maturity should you buy if you think rates are going higher? The answer, shorter term maturities. The value of short term bonds is more stable in a rising interest rate environment. As rates rise, your portfolio will be more stable and you will have bonds maturing enabling you to reinvest at the current higher rate.