Bonds and fixed-income securities have become much more popular investments these past few years, as Federal Reserve hikes have led to much higher yields. Bonds and bond funds vary, with different characteristics including maturities and credit risk. In this article, I'll be comparing short-term and long-term bonds, looking at how their dividends, returns, and risk, compare.
Yield Comparison
Short-term bonds currently yield more than long-term bonds, holding credit quality constant, and with a few exceptions. As an example, short-term treasuries tend to yield less than long-term treasuries, with a couple exceptions in the curve.
As another example, benchmark short-term high-yield corporate bond ETFs yield more than broader high-yield ETFs. There are some exceptions here, however.
The above is a significant advantage of short-term bonds, at least right now.
In most cases, long-term bonds tend to yield more than short-term bonds, as compensation for their added interest rate risk, and due to tying up investor capital for longer. As an example, 10y treasuries have yielded more than t-bills during most of the past decade.
Current conditions are an exception to the long-term trend, and are unlikely to persist for long, as the Federal Reserve will likely cut rates in the coming months.
Due to the above, long-term bonds tend to outperform short-term bonds. This is the case for t-bills, medium-term treasuries, and long-term treasuries, for the past two decades or so.
Nevertheless, as short-term bonds do yield more than long-term bonds right now, short-term bonds remain a strong investment opportunity right now. I would personally pick short-term over long-term bonds at the present time, although more dovish investors might disagree.
Although the above seems a bit obvious or redundant, I don't think it is. In most cases, short-term bonds yield much less than long-term bonds. That is not the case right now, and I think that is an incredibly important fact for investors to consider, and an important advantage of short-term bonds. T-bills have not offered competitive yields in over a decade, so these are much more attractive investments now than in the past.
Capital Gains Comparison
In most cases, bonds are income vehicles, so potential capital gains are low. Right now, the situation is a bit different. Prior Federal Reserve hikes led to lower bond prices, as investors sold off their older, lower-yielding bonds to buy newer, higher-yielding alternatives. Short-term securities were not all that impacted, as these have (mostly) matured by now, and due to their lower duration. Long-term securities saw much higher losses, due to higher selling pressure / duration.
As an example, compare prices for benchmark t-bill, medium and long-term treasuries since early 2022, when the Fed started to hike.
Due to the above, longer-term bonds have much greater potential capital gains than short-term bonds right now. For gains to materialize, investors must either wait for bonds to mature, which could take decades for long-term bonds, or for buying pressure to increase, which should occur if the Federal Reserve hikes rates aggressively. Slower, more methodical rate hikes might not necessarily lead to higher bond prices, however.
Total Returns Comparison
Bonds are income vehicles, so long-term returns are almost entirely composed of, and dependent on, dividend yields. As long-term bonds generally yield more than short-term bonds, their long-term returns are higher.
On the other hand, as short-term bonds currently yield more than long-term bonds, I think there is a very strong argument to be made that short-term bonds will outperform in the coming months. This has been the case these past few years, but mostly due to lower bond prices, not the dividends themselves (those did help though).
Overall, I would expect long-term bonds to outperform short-term bonds long-term, but by much less than average.
Credit Risk Comparison
Bond maturities do not directly, or necessarily, impact credit risk or annual default rates. Short-term securities can be high-quality, think t-bills, or low-quality, think short-term high-yield bonds. Same with long-term securities. Nevertheless, there are several important trends or caveats to this.
Long-term securities tend to be high-quality holdings, as generally only high-quality issuers are capable of issuing long-term debt at reasonable prices. Some quality issuers focus on long-term debt to lock-in rates as well. There are many exceptions to this, but the trends are real, and do impact bond markets. As an example, compare the maturity and duration of the largest investment-grade and high-yield bond ETFs:
Comparing maturity dates for investment-grade and high-yield bonds shows a similar pattern, with a greater percentage of investment-grade bonds having maturities of +5 years than high-yield bonds.
Short-term investment-grade securities are arguably safer than comparable securities of longer maturities, as safe, quality companies almost never go bankrupt in a short amount of time. Apple (AAPL) can't conceivably go bankrupt next month, not with a $162B war chest. It could, perhaps, go bankrupt in a couple of years, assuming sales plummet and the company starts hemorrhaging cash.
Default rates data shows the same, with AAA-rated bonds having a 0.00% default rate in a 1y time horizon, rising to 0.69% at the 10y mark. AAA-rated bonds do sometimes go bankrupt, but the process effectively always takes more than one year. Default rates for bonds with other credit ratings shows a similar pattern.
In my opinion, and considering the above, I think it would be fair to say that short-term bonds are somewhat safer than long-term bonds, keeping credit ratings constant. On average the opposite is true, as long-term bonds are generally of higher quality than short-term bonds. I wouldn't personally draw any significant conclusions from these issues, but the analysis was warranted regardless.
Interest Rate Risk Comparison
Most bonds have fixed rates from issuance until maturity. Buy a 2y treasury today, and you'll receive 4.6% in interest every year for two years. Buy a 10y treasury today, and you'll receive 4.2% in interest every year for ten years. Interest rates on treasuries as a whole might change, but the interest rate on the individual treasury you bought will remain the same from issuance until maturity.
Importantly, interest rates on newly-issued treasuries and bonds do change all the time, and the impact is a bit different depending on the bond's maturity.
Investors in short-term bonds tend to see strong, swift changes to their dividends and yields when interest rates change. Investors in t-bills must generally wait only a month or two before their t-bills are rolled over, and rate changes to take effect. Investors in the SPDR Bloomberg 1-3 Month T-Bill ETF (NYSEARCA: BIL) have seen their yields rise from 0.0% in early 2022 to 5.0% as of today, broadly in-line with Fed hikes.
Investors in long-term bonds see much lower, and slower, changes to their dividends and yields when interest rates change. Investors in 10y treasuries must generally wait ten years for their treasuries to mature, and for new rates to take effect. Investors who bought 10y treasuries in early 2022 at a 1.5% yield are stuck with that measly yield for ten years, regardless of what the market does in the interim.
Investors in bond funds generally see somewhat more rapid changes to their dividends and yields when rates change, as these almost always hold hundreds / thousands of securities, and at least a portion of these mature or get replaced relatively quickly. As an example, investors in the iShares 7-10 Year Treasury Bond ETF (NASDAQ: IEF) have seen their yields increase from 0.8% to 3.0% during the current hiking cycle. Dividends have increased, but at a much slower pace than t-bills, less than half the speed.
Corollary of the above is that long-term bond prices are also heavily impacted by changes in rates. Investors in 10y treasuries will shift from treasuries to t-bills if the Fed hikes, in search of higher yields. As an example, IEF's share price has declined by 18.7% since early 2022.
Longer-term bonds see even greater declines from the above, as they suffer much more from higher rates (being stuck at low yields for longer / higher duration).
Short-term bonds see much lower impact, as they can be replaced relatively quickly. BIL's share price has not been materially impacted by higher Fed rates, for instance.
Considering the above, short-term bonds tend to outperform when interest rates rise, seeing strong dividend growth and price stability. As an example, t-bills have outperformed treasuries since early 2022.
On the flipside, long-term bonds tend to outperform when rates decline, seeing strong capital gains when this occurs. As an example, treasuries outperformed t-bills during 2020, when the Fed slashed rates in light of the pandemic.
Overall, long-term bonds have much more interest rate risk than short-term bonds. This increases overall portfolio risk and volatility, an important negative for shareholders. At the same time, for dovish traders higher rate risk means higher potential gains from lower rates.
Reinvestment Risk / Lock-In Rates Comparison
Short-term bonds have higher reinvestment risk, which means that investors might not necessarily be able to re-invest their cash or roll over their investment at a rate comparable to their current rate of return. As an example, investors in t-bills might not be able to roll over their securities at +5.0% in the coming months, as the Federal Reserve is likely to cut rates.
Long-term bonds have much lower reinvestment risk, as most bonds are fixed-rate, and so rates are locked-in for several years. Investors in 10y treasuries, for instance, don't have to worry about rolling over their securities for ten years, a very long amount of time.
Reinvestment risk is a particularly important issue for retirees. Retirees focusing on t-bills might see their income decline quite rapidly and might have to pivot to other asset classes if rates decline. Retirees focusing on 10y treasuries only face these issues every decade.
Reinvestment risk is also an issue insofar as it makes retirement planning difficult. Retirees focusing on t-bills might have issues forecasting their income a couple of months into the future. Retirees focusing on 10y treasuries have a much clearer idea of their income for the next decade.
Overall Risk Comparison
Short-term bonds have lower interest rate risk than long-term bonds, which means lower risk and volatility on most traditional metrics. Investment-grade bonds have low credit risk too, so short-term investment-grade bonds have the lowest volatility of all.
The impact of the above is particularly impactful when interest rates are in flux, as they currently are. As an example, treasuries are always more volatile than t-bills, but spreads have widened since early 2022, when the Fed started to hike rates aggressively.
An issue with the figures above is that these do not take into consideration reinvestment risk. In my opinion, the more traditional risk and volatility metrics centered on prices do a good job at measuring a bond's risk, which means that short-term bonds are materially less risky than long-term bonds. Some investors might consider dividends and reinvestment risk to be more important, in which case long-term bonds look less risky.
Overall Risk-Return Profile
Long-term bonds generally have higher yields and returns than short-term bonds, although that is not the case right now.
Long-term bonds are generally riskier too, and more volatile. This is particularly true right now, as interest rates are in flux.
In my opinion, and considering the above, short-term bonds have much stronger overall risk-return profiles than long-term bonds. Short-term bonds are much safer, while prospective returns seem only somewhat lower, with lots of uncertainty. Under these conditions, I prefer short-term bonds over long-term bonds. I've thought as much for years, and most of my top picks in this area have performed quite well. Returns have been quite strong YTD, but the real test will come when the Fed starts to cut rates.
Conclusion
Short-term and long-term bonds have many similarities and differences between them. I've covered some of the more salient of these in this article. Hopefully the information here was of use and interest to readers.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
At the CEF/ETF Income Laboratory, we manage closed-end fund (CEF) and exchange-traded fund (ETF) portfolios targeting safe and reliable ~8% yields to make income investing easy for you. Check out what our members have to say about our service.
To see all that our exclusive membership has to offer, sign up for a free trial by clicking on the button below!
