[Investing] Why choose short-duration bonds?

The return on a bond is composed of coupon and price changes. Bond yields are an important indicator of the bond market and are inversely related to bond prices. Assuming all factors remain constant, when yields rise, bond prices fall. Factors driving yields include changes in credit ratings and interest rates.

What is the yield curve?

The yield curve reflects the yields of bonds with the same credit rating but different durations on a line (that is, the annualized yield until maturity). Yield curves are generally divided into three types, 1) upward sloping; 2) downward sloping or inverted; and 3) flat.

When the economy is growing, we typically see an upward-sloping yield curve, with longer duration bonds generally offering higher yields to compensate bond investors for the additional risk (such as interest rate risk) they are exposed to. A downward or inverted yield curve may signal a recession, with investors anticipating lower interest rates to stimulate economic growth; while the transition period between these two scenarios may see a flat yield curve.

How do interest rates affect bond yields?

The interest rates set by central banks are key to the cost of borrowing for businesses or governments. When inflation slows, central banks often lower interest rates to stimulate spending and economic activity. In such an environment of slowing inflation, bond yields tend to fall as borrowing costs fall, and companies accelerate investment and production. When inflation rises, the central bank will raise interest rates to cool the overheated economy, reversing the situation.

Why Choose Short Duration Bonds When Interest Rates Are Rising?

Duration is measured in years and reflects the sensitivity of bond prices to changes in interest rates. The longer the duration, the more sensitive the price will be to changes in interest rates. Short-duration bonds (ie, up to 5 years) generally provide better protection against interest rate fluctuations than longer-term bonds.

For example, assuming other factors remain unchanged, when interest rates rise by 1%, the prices of bonds with durations of 2 years and 4 years will fall by just under 2% and 4% respectively. Conversely, when interest rates are cut by 1%, a bond with a duration of 2 years will experience a price appreciation of approximately 2%, while a bond with a duration of 4 years will experience a price increase of approximately 4%.