Low Interest Rates and Long Term Bonds

A bond's interest rate should reflect the general potential for risk and profit on the bond. For example, a low risk bond will have a lower potential for loss or profit, meaning it will have a lower interest rate. A high risk bond creates a great potential for loss or profit, so the interest rate will be higher. This relationship of interest rate to risk exists on corporate and municipal bonds alike. Generally, long term bonds are riskier than short term bonds, so the interest rate should be higher. A low risk, long term bond in inadvisable, unless it has protection against default and inflation.

Short Term Bond Risk

Short term bonds are less risky than long term bonds for several reasons. First, your money will be held for a shorter period of time. You will have access to the cash in as soon as one year. If your income changes or your investment priorities change, you will receive the money back soon, and you can adjust your decision accordingly.

With a long term bond, your money is help up for a much longer period of time. You will only be able to free up your cash by selling the bond, trading in any potential for future earnings or payments from the interest rate on the bond. In addition to the amount of time you will have to pledge your funds for, long term bonds are riskier due to an increased chance of default and inflation.

Default Protection on Long Term Bonds

Default becomes a greater risk the longer you hold a bond. If you buy a bond from a corporation in good standing today, you will likely believe the corporation will be in good standing a year from now. However, it can be less certain to know this corporation will be in good standing 10 years from now, since the economy or industry can change drastically.

A long term bond should compensate for this risk with a higher interest rate. Treasury bonds have no real risk of default since the US Treasury can print more money to repay the debts. Long term Treasury bonds do have a higher interest rate than short term Treasury bonds, but this is to compensate for inflation and not risk of default.

Inflation Protection on Long Term Bonds

The longer you hold a bond, the more inflation will decrease the value of a dollar. With a long term bond that matures over 15 years, you will find the value of a dollar changes drastically. You cannot anticipate how much inflation will change over the life cycle of your bond, even with solid estimates. Corporate bonds compensate for this by offering higher interest rates on long term bonds. Some Treasury bonds have inflation protection. These bonds have two separate rates. The first is the rate offered on the bond, and the second rate compensates for inflation. Inflation protected securities are among the safest bonds on the market. If you are going to elect a long term bond that is not inflation protected, opting for a high interest option is preferable to selecting a low interest option. 

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