Why Do Short-Term Bonds Have More Investment Risk?

A 60/40 investment portfolio is a traditional allocation of equities and bonds. Meaning that 60% of the portfolio is invested in equities and 40% in bonds. This split is meant to counter peaks and troughs in equities. Periodic rebalancing is also needed to maintain the allocation.

Within the 40% part of the portfolio, various types of bonds can be held — short-term, long-term, government, corporate, and junk. Specifically for short-term bonds, do they carry more investment risks than other bonds?

What Are Short-Term Bonds?

Short-term bonds have a maturity of between 1-5 years. They mature quicker than intermediate or long-term bonds. Because of their short maturities, these bonds have less volatility than longer-dated bonds and less sensitivity to interest rate moves.

Yields for short-term bonds are generally 1.00%-1.50%. These bonds are for those seeking capital preservation. Short-term bondholders give up any upside potential for capital preservation due to lower yields. However, the yield is usually a little more than savings accounts and money market funds.

Capital preservation in short-term bonds is not a guarantee. The bondholder can still lose part or all of their principal. Short-term bonds are not FDIC insured. Government bonds are backed by the full faith and credit of the United States and are considered very safe. The same can't be said for short-term corporate bonds.

Drops in short-term bonds are generally much less severe than equities or longer-dated bonds. For example, while equities may drop 30-40%, short-term bonds may lose only 5-10% of their value.

Short-term bonds have capital preservation with little return. This is due to short-term bonds' lack of upside participation in the bond market compared to intermediate and long-term bonds. 

In comparison, long-term bonds are those maturing in 20-30 years. Yields on these bonds are in the 3-4% range, and they pay higher coupons. They are also far more volatile than short-term bonds.

Generally, when the equities move sharply lower, long-term bonds tend to move in the opposite direction. However, short-term bonds don’t move much as they are not as sensitive to sharp changes in equities.

On the flip side, when equities move higher, long-term bonds can move lower. But again, short-term bonds remain fairly steady.

At a high level, long-term bonds will move opposite to equities, which provide a counterbalance in a portfolio. Additionally, this allows portfolios to rebalance allocations. For example, long-term bonds are likely much lower when equities are high, creating an opportunity to rotate positions and bring them back into alignment (i.e., sell equities and buy bonds).

If an investor only owns short-term bonds, he'll have to own a large overall position if the goal is to protect a portfolio from market moves. However, with a mix of long and short-term bonds, long-term bonds help offset market volatility, decreasing the need to own a large number of short-term bonds.

The following ranks short-term bonds by safety:

1. Cash
2. Savings account or CDs
3. Money market
4. Short-term bonds (first government, then corporate) 

To get to the main question, do short-term bonds have more investment risk than longer-dated bonds?

Short-Term Bonds And Investment Risk

What do we mean by short-term bond investment risk, and do short-term bonds have more of it? Most people buy bond funds rather than actual bonds. But in general, the risks are similar.

For a short-term bondholder who purchases a 2-year bond yielding 1.05%, if interest rates move below 1.05%, investors are willing to pay more for the higher-yielding bond. On the other hand, if interest rates move to 1.25%, the bond will lose value as investors seek higher-yielding bonds. That is the investment risk bondholders face. 

Do short-term bonds have more investment risk than intermediate or long-term bonds? This is really subjective and depends on an investor's portfolio allocation. For an investor with a small holding of short-term bonds, their exposure has little impact on the portfolio. But for an investor with a large holding of short-term bonds, their exposure can greatly impact the portfolio.

So, to answer the question: Do short-term bonds have more investment risk? It depends on the investor's exposure to short-term bonds.

Short-term bonds mean an investor has a short-term outlook on interest rates. In other words, the investor is trying to time the market, which is very difficult to do. On the plus side, short-term bonds have a short maturity allowing the investor to rotate into different yields more frequently than intermediate or short-term bonds.

Regarding bond funds, a short-term bond fund can lose principal when yields fall. Meaning, an investor purchases $10,000 of a short-term bond fund and yields fall, the value of the investment may go down to $9,800. Of course, the drop can be far more for longer-dated bond funds.

Having a mix of various maturities is considered good bond diversification. The largest fixed-income category in the fund industry is intermediate-term bonds, and for good reason. They sit in the middle of short and long-term bonds, providing a compromise between the two. This doesn’t mean an investor’s bond holdings should only be in intermediate bonds. By working with a financial advisor, investors can make a better determination about their bond allocations.