How to Choose the Right Bond Funds

Series I Bond Annual Purchase Limits

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One of the most important aspects of investing in bond funds and ETFs is understanding the differences in the risks and return characteristics of bonds with different maturities. Typically, the fund universe is divided into three segments based on the average maturities of the bonds in the funds’ portfolios:

  • Short-term (less than 5 years)
  • Intermediate-term (5 to 10 years)
  • Long-term (more than 10 years)

The Relationship Between Risk and Yield

Short-term bonds tend to have low risk and low yields, while longer-term bonds typically offer higher yields but also greater risk. As their name would suggest, intermediate-term bonds fall roughly in the middle.

Why is this? Very simply, buying a longer-term bond locks up the investors’ money for a longer period than a short-term bond, which leaves more time for interest rate movements to affect the bond’s price. Virtually all bonds with maturities of more than a year are subject to the risk of price fluctuations stemming from interest rate risk. The longer the time until maturity, the larger the potential price fluctuations. The shorter the time until maturity, the lower the price fluctuation.

Also, short-term yields are more affected by the policy of the U.S. Federal Reserve, whereas the performance of longer-term bonds is largely determined by market forces. Since investor sentiment changes much more rapidly than Fed policy, this too leads to more intense price fluctuations for long-term bonds.

Bond Performance During Times of Rising and Falling Rates

The table below shows an example of how the rate movements affect returns. Based on data from January 24, 2014, a one-percentage-point increase in prevailing rates would have had the following impact on Treasury prices:

  • 2-Year: -1.9%
  • 5-Year: -4.7%
  • 10-Year: -8.5%
  • 30-Year: -17.8%

Keep in mind; this is only an example based on snapshot data from a single day. This data should be used to infer the proportional movements of bonds of varying maturities over time, but it does provide an illustration of the higher volatility associated with longer-term bonds.

Determining What’s Best for You

Investors typically adjust their portfolios toward one end of the other based on their risk tolerance, objectives, and time frame.

For instance, an investor for whom safety is the top priority would typically sacrifice some yield in exchange for the greater stability and lower risk of loss present in short-term bonds. On the other hand, an investor with higher risk tolerance and more time until he or she needed to tap into his or her principal could take on more risk in exchange for the higher yields available in long-term bonds.

There’s no single right answer as to which approach is the better choice; it all depends on the individual’s situation. However, it’s important to keep in mind that long-term bond funds, due to their higher volatility, aren’t appropriate for someone who needs to use the principal within three years or less.

How to Invest in Each Category

Investors have a wide variety of ways to invest in short-, intermediate- and long-term bonds. The two most popular approaches are to use mutual funds or exchange-traded funds.

Morningstar has organized bond funds by their maturities on its website, which can provide investors with a starting point for further investigation. The following links show the funds in each category:

  • Short-term bond funds
  • Intermediate-term bond funds
  • Long-term bond funds

Exchange-traded funds (ETFs) also offer investors a variety of options in each category. As is the case with mutual funds, many are segmented not just by their average maturity, but also by what segment of the market they cover. For instance, investors have a choice among short-, intermediate-, and long-term bonds within the government, municipal, and corporate bond categories.

Intermediate-term bond funds are by far the largest of the three categories. The reason for this is simple: index funds and those that tend to invest across the full spectrum of the bond market tend to average out to an “intermediate” maturity. Take care to distinguish between funds that fit this description versus those that are specifically dedicated to intermediate-term bonds.

Longer-Term Bonds Don’t Always Produce Higher Total Returns

When looking at funds’ performance results, it’s important to keep the historical context in mind. In January 2013 - a few months before the bond market began to weaken - an investor who looked at Morningstar’s bond fund categories would have seen these average annual returns for the three maturity categories over the previous ten years:

  • Short-term bond funds: 3.03%
  • Intermediate-term bond funds: 5.65%
  • Long-term bond funds: 8.53%

Why are the returns for long-term bonds so much stronger? Largely because these results reflected the tail end of a 31-year bull market in bonds. When rates are falling, longer-term bonds will produce higher total returns. Once rates began to rise, however, this relationship was turned on its head. For the full 2013 calendar year, the short-, intermediate, and long-term categories returned 0.45%, -1.45, and -5.33%, respectively.

The takeaway: no matter what the total return tables say at any given time, keep in mind that longer-term usually equates to higher yields, but not necessarily higher total returns.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.