Should You Buy Bonds With More Than Three Years to Maturity?

Bonds can look straightforward. An investor lends money to a government or company, receives interest and expects the principal to be repaid at maturity.

The difficulty is that a bond’s value can move significantly before that date. A bond paying an attractive rate of interest can still produce a disappointing short-term return if market yields rise.

That does not make bonds inherently unattractive. It means investors need to understand what drives their returns, particularly when considering maturities beyond three years.

Bond returns have two moving parts

A bond’s return comes from income and changes in its market price.

The starting yield is important because it indicates the return implied by the bond’s current price, future interest payments and repayment value. Yield to maturity assumes the bond is held until maturity, payments arrive as expected and relevant cash flows are reinvested under the calculation’s assumptions.

However, the actual return can differ, especially if the bond is sold early or the issuer fails to make a payment. FINRA’s guide to bond yield and return explains why yield is a useful starting point rather than a guaranteed outcome.

Market prices provide the second moving part. If prevailing yields rise after a fixed-rate bond is issued, newly issued bonds may offer more competitive income. The older bond generally has to fall in price to remain attractive.

The reverse can also happen. If yields fall, an existing bond’s fixed payments may become more valuable, causing its market price to rise.

Duration measures interest-rate sensitivity

Maturity tells you when a bond is due to repay its principal. Duration estimates how sensitive its price is to changes in yields.

As a rule of thumb:

Approximate price change = minus duration multiplied by the change in yield

Suppose a bond fund has a duration of six years. If relevant yields rise by one percentage point, its price could fall by roughly 6%, before allowing for income and other factors.

This is an estimate, not a promise. Nevertheless, it is a useful way to compare risks. A fund with a duration of two years should normally be less sensitive to the same rate movement than one with a duration of ten years.

The practical lesson is that a bond can have relatively low credit risk while still carrying substantial interest-rate risk. Government backing may reduce the risk of missed payments, but it does not stop the market price from fluctuating.

Why the extra maturity might not be worth it

Moving from cash or short-dated bonds into longer maturities usually means accepting more duration risk. The key question is whether the additional yield adequately compensates for that risk.

A longer maturity may be less appealing when:

• the extra yield over short-term alternatives is modest;
• the money may be needed before the bond matures;
• temporary capital losses would be difficult to tolerate;
• inflation could erode the purchasing power of fixed payments;
• the investment already has considerable exposure to interest-rate movements.

This is why the headline yield alone is not enough. Two funds can display similar yields while having very different durations, credit quality and potential volatility.

Investors should also check whether the quoted figure is a running yield, distribution yield or yield to maturity. They measure different things and should not be treated as interchangeable.

An individual bond is not the same as a bond fund

An individual bond has a defined maturity date. Assuming the issuer meets its obligations, an investor holding it to maturity expects to receive the stated principal value, regardless of price movements along the way.

That can make interim volatility easier to manage, but it does not remove inflation, credit, liquidity or opportunity-cost risks. Money is also committed unless the bond can be sold at an acceptable price.

A conventional bond fund usually has no single maturity date. Its manager continually replaces bonds as they mature or leave the fund’s target range. This provides diversification and convenience, but investors cannot simply point to one date when all principal will be returned.

For a bond fund, duration and portfolio quality are therefore particularly important. FINRA’s broader introduction to bonds and their risks provides a useful overview of these distinctions.

Bonds can do more than express a view on rates

A common mistake is to treat a bond allocation purely as a bet that interest rates will fall.

High-quality bonds can serve several possible roles, including generating income, reducing overall portfolio volatility and balancing some equity exposure. Their purpose depends on the investor’s objectives and the type of bonds selected.

There is no guarantee that bonds will rise whenever shares fall. Credit-sensitive corporate bonds can decline alongside equities during periods of financial stress. Longer-dated government bonds may also struggle when inflation or rate expectations rise.

Diversification therefore depends on what is owned, not simply whether an investment carries the label “bond”. Currency exposure matters too. UK investors considering overseas fixed income should examine whether exchange-rate movements are hedged, as discussed in why foreign bonds can still appeal when domestic yields rise.

A compelling story can still be a fragile strategy

It is easy to construct a chain of events in which shares decline, economic activity weakens, central banks reduce rates and longer-dated bonds rise sharply.

Each step is plausible. The problem is that every step must occur in roughly the expected order and timescale.

Inflation could remain persistent. Bond yields could rise even during weaker economic conditions. Corporate credit spreads could widen. Rate reductions might already be reflected in market prices. Equities and bonds could also fall together.

Avoiding bonds until the outlook feels safe has a similar weakness. If yields decline before an investor acts, some of the potential price gain and the opportunity to secure the earlier yield may disappear.

Timing fixed-income markets is not automatically easier than timing shares. Both require an investor to be more accurate than the expectations already embedded in prices.

Match the bond risk to the job

Rather than beginning with a prediction, start with the purpose of the money.

Consider these questions:

1. When might the capital be needed?
2. How large is the investment’s duration?
3. What happens if yields rise by one or two percentage points?
4. Is the additional yield worth the extra rate risk?
5. What is the issuer’s credit quality?
6. Is the bond exposed to foreign currency movements?
7. Is the goal income, capital stability, diversification or a tactical rate position?

Longer-dated bonds are not automatically safe or dangerous. They exchange greater sensitivity to yields for the possibility of locking in income for longer and benefiting if yields fall.

The durable principle is simple: do not take more duration than the portfolio’s objective, time horizon and tolerance for price movements can support. A bond allocation should have a defined job, rather than depend entirely on one confident forecast about what markets will do next.