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Long Bonds vs. Short Bonds sample essay
The main difference between long bonds and short bonds is that long bonds generally mature in ten or more years, while short bonds, which are also referred to as bills, mature in two years and less. When investing money into a governmental organization, corporation, or company, investors receive bonds, which they hope to redeem later for their money. The essential point of a bond is that an investor receives greater amount that he or she invested, that is the actual money invested plus interest. Long-term bonds generally pay investors higher yields, while short-term bonds pay in lower yields. However, in specific cases short-term bonds pay greater amounts to investors.
The key factor that affects the yield the investor receives is the interest rate. It is truly essential as well as obvious that the higher the interest rate, the greater amount the investor will receive. The amount that the investor receives in the end is called the maturity value. The maturity value, or yield, depends on several factors, the most important of them being the principal value (that is the amount invested), the interest rate, and period of investment. Yield is the return you actually earn on the bond based on the price you paid and the interest payment you receive. There are basically two types of bond yields, which are the current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price. Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity plus any gain or loss. Yield to call is calculated the same way as yield to maturity, but assumes that a bond purchased at a premium will be called and that the investor will receive face value back at the call date. Buying a bond based only on current yield may not be sufficient, since it may not represent the bond's real value to your portfolio.
So let us take two different institutions A and B as an example, both offering the same interest rate. And let us assume that person I invest the same amount in these two institutions separately, only institution A offers long bonds, and institution B - short-term bonds. The question arises, will L be paid the same amount by A and B in the end? Or, will L receive more from A? Or from B? The answer is, of course, institution A will pay off higher yield. Now let us look closer into the scheme to see the important key details.
Institution A offers bonds that mature within say, ten years, that is why the maturity value is different from that of institution B, which offers only one-year maturity period. We know the principals are the same amount is both cases, and the interest rates are also similar. So it is obvious that while B pays out the yield to L, the yield will only comprise the principal plus interest for only one year. However, while B pays off the yield, the money invested in A are still working accumulating interest with each year. So in nine years then, when A pays off the yield, the amount will comprise this same principal plus interest not for one year, like in case with B, but for ten years. Therefore, interest earned will be ten times greater than in B case. No matter what the principal is, this difference is appreciable, and in this case, yield provided by A will be almost twice as high as yield paid off by B (with 10% or so interest rate). So generally, yields on long bonds exceed yields on short bonds, as we see in this example.
However, there is a possibility to receive greater yield on a short bond. Let us turn to A, B, and L, with which we are already familiar to turn the concept simpler. In this case, institution B will pay off higher maturity value to investor L, offering only one-year maturity period. Institution A offers long-term bonds that mature within ten-year period, and it will pay of lower amount to L in the end. Again, we assume that principal values, the money person L invested in each company, are the same. And unlike in the first example, here the key feature will be the difference in the interest rates, so institution A will have to offer much higher interest rate in order to pay off greater amount.
First, let us set the interest rates for each institution. Let company A offer a 16% interest rate, while company B offers only 1.5%. A knowledgeable investor would notice such a substantial difference at once, and conclude that company A is either a new company or it is very unstable. It is obvious that huge, stable, corporations would only offer up to 5% interest. And on the contrary, unstable, unknown companies want to attract new investors, that is why the offer such high rates, just like in our second example. Institution B, however, is too stable. 1.5% percent is too a little rate, but we are using it to illustrate only.
In general, such 16% interest rates are suspicious, because the following rule always applies: the higher the interest rate, the riskier the investment. To evaluate exactly how much risk is present when we invest in the bond market at this time is not an easy task, and to predict how the investors will react is even more difficult. All the predictions based on any theory have a basic assumption that investors are objective and rational. Although it may seem to be true, there are investors who still rely on rumors and instinct to make their investment decision. Patriotic investors may even choose to forsake higher returns to support their country to fight their enemies by buying government bonds with lower returns. Therefore, it is not enough to look at statistical data only, and it is also beneficial to examine the psychology of the investors in the market.
So, institution A can provide higher yield only if it offers much higher interest rate. Let us assume that L invests 100,000 in each company. In ten years, company B will pay L this much, 100,000+100,000x1.5%x10=115,000. However, company A will pay off L more, 100,000+100,000x16%=116,000, and note that only one year will have passed. This simple example demonstrates how yield on short bonds can exceed yield on long-term bonds. The important key factor to remember is the interest rate and its effect on the maturity.
The two examples with institutions A and B, and investor L are consistent with each other, however they are mutually exclusive. In other words, the consistency of these two explanations consists in the fact that the key factor in both examples is the interest rate. Every substantial and important part is dependent on the interest rate of the organization. In the first example, we assumed that the two companies offered the same interest rates just to illustrate that in most cases yield on long bonds is higher than yield on short bonds. Of course another important factor to turn to, if the interest rates are the same, is the maturing period. In this case this very factor influenced the difference between the maturity values, because principals, and interest rates were the same. In the second explanation, the time frame remained the same as in the first one, and the principals remained the same, but interest rates were changed in order to illustrate the possible outcome. In this example interest rate was not the only key factor, but also the maturity periods. Assuming the two institutions offered substantially different interest rates (both rates are rare cases in real life), we examined how higher interest rate and shorter period can result in higher yield.
The mutual exclusiveness of these explanations means that it is impossible in fixed conditions to have at the same time higher and lower yields on long bonds. From this point of view, the two explanations are inconsistent, because it has to be either one way, or another. Since finance “speaks” in the language of numbers and mathematics, two possible outcomes cannot happen at the same time. Anyway, ultimately, the key factors to keep in mind concerning short and long bonds and differences in yields on either of them, are the interest rates, and the maturity periods. Principal is important too, but not like these two.
Bibliography
1. Bond Center. Bond Glossary. Yahoo! Finance. 2004.2. Economic Statistics Briefing Room. Bond Page: Fixed Income Specialists.
3. Lott, Chris & Carriero, Rich. Bonds: Relationship of Price and Interest Rate. 1997.
4. Cohen, Marilyn. The Bond Bible. Prentice Hall Press. 2000.
5. Temel, Judo Wesalo. The Fundamentals of Municipal Bonds. Wiley. 2001.
6. Thau, Annette. The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More. McGraw-Hill. 2000.
7. Crescenzi, Anthony. The Strategic Bond Investor: Strategies and Tools to Unlock the Power of the Bond Market. McGraw-Hill. 2002.
8. Hassan, Steven. Releasing the Bonds: Empowering People to Think for Themselves. Aitan Publishing Company. 2000.
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