Short-term bonds have maturities of three years or less. They tend to pay lower interest rates than other types of bonds. But in return, investors get the safety of having their money at risk for only a short period. Interest rates determine the value of short-term bonds. Investors who have strong opinions about the direction of interest rates in the near future have several moves they can make with short-term bonds.
Falling or Low Interest Rates and Bond Prices
Short-term bonds can go up in value when interest rates fall. If interest rates go below what a bond pays, investors will be willing to pay more for it. Any new bonds they buy will pay a lower interest rate. In an environment of steady interest rates, short-term bonds can maintain their value as long as they pay better than the current rate.
Rising Interest Rates and Bond Prices
Short-term bonds lose value if interest rates go higher than the bonds pay. Investors will be less willing to buy a short-term bond that pays less than the current interest rate because they can simply buy a new bond and get that rate. That means an investor trying to sell a short-term bond with a lower interest rate will have to discount the bond to attract investors.
Strategy for Rising Interest Rates
When interest rates are rising, the short-term bond investor can simply wait for the bond to mature and then take the principal and put it in a new higher-rate bond. An investor could find that it's worth holding the bond to maturity rather than sell it at a discount. Although the interest rate will be lower than the market is paying, the investor will soon be able to get that new rate.
Short-term Bonds for Parking
Investors can use short-term bonds as a temporary parking place if interest rates don't have any clear direction. This will provide some income until interest rates enter a definite trend. If the issuing company for the bond is in good financial condition, the investor has a fairly low risk of losing money. As long as the company pays its interest payments, the investor gets income. The investor will also get her money back soon because of the short maturity. At that point, she can make a new assessment about the direction of interest rates.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.