Bonds are debt securities issued by corporations, municipalities or other government entities. When you buy a bond, you are loaning money to the issuer for a set period in exchange for the promise of a return of the bond's face value plus interest. You can make money on bonds from both interest payments and capital gains. Both of those factors are affected by whether the bond has a long- or short-term maturity.
Bonds are referred to as either short or long term, depending on how much time remains before they mature, although there is some disagreement as to what constitutes short term or long term. The Kiplinger website refers to any bond with a maturity of more than 10 years as long term and bonds with less than three years as short term. The Securities Industry and Financial Markets Association calls bonds with maturities of up to five years short term and those with maturities of at least 12 years long term. The U.S. Department of the Treasury uses 10 years as the benchmark for long-term bonds and two years or less for short-term debt instruments.
When you compare the interest rates on a short-term bond and a long-term bond issued on the same date by the same issuer, the short-term bond will typically offer a lower rate than the long-term bond. The difference can be attributed to the uncertainty of the future. While you might be able to forecast a company's prospects in the short term, its fortunwa in the distant future are less certain. This uncertainty results in greater risk for long-term bonds than for short-term bonds. A higher interest rate is usually required to compensate investors for taking the extra risk.
Bonds are rated for their risk by independent ratings organizations, such as Standard & Poor's or Moody's. A higher bond rating typically results in a lower interest rate, and vice versa. A short-term bond with a low rating might offer the same interest rate as a similar long-term bond that has a high rating, to compensate for the additional risk.
Both long-term and short-term bonds are interest-rate sensitive; that is, the market price of bonds tends to move in the opposite direction of prevailing interest rates. For example, you wouldn't pay $1,000 for a 10-year bond paying 5 percent interest in the secondary market when you could pay $1,000 for a new-issue 10-year bond paying 6 percent. The market price of the 5 percent bond would have to drop to be competitive with current interest rates. Short-term bonds are less sensitive to such price swings than long-term bonds, since they don't have as long to pay interest.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.