Bonds – Maturity plus Interest Rates = Volatility and Risk

When it comes to investing in bonds, some of the basics related to bond risks tend to elude investors. Most understand the risks associated with stocks. If you invest in a stock and its price rises, you make money, if it falls, you lose. But bond risk has many different components. One of those risks is how the interest rate and maturity affect bond prices.

The maturity of a bond is the date the principal amount is repaid and the issuing organization returns your investment to you. You can buy bonds with maturities from one week to one hundred years. Clearly, the maturity (or maturities) you select must be aligned with your investment objectives.

As a general rule, most investors should consider bonds with maturities of 20 years or less. Many investors spread out the maturities of various bonds in a portfolio to create a “ladder structure.” This creates a mix 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. Among from time to time, 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 go up, the present value of a bond will go down. If interest rates go down, the present value should go up. 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’ll receive your principal back and the sooner you can reinvest at current rates. The shorter time frame reduces the risk of something going 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. Higher maturity, more risk, higher interest rate.

Which maturity should you buy if you think rates are going to go up? The answer, shorter maturities. The value of short-term bonds is more stable in an environment of rising interest rates. As rates rise, your portfolio will be more stable and you will have maturing bonds that allow you to reinvest at the current higher rate.