Investments in Bonds: Long-Term Bonds Exhibit Greater Volatility
Bonds constitute a vital element in many investment portfolios, competing not only with stock investments but also with traditional interest-bearing assets. Investors are advised to look beyond factors such as interest rates, inflation, and the creditworthiness of the issuer or bank, along with deposit insurance, and consider additional nuances. For instance, it’s important to keep an eye on market values of bonds. Pascal Kielkopf, a capital market analyst from asset manager HQ Trust, mentions that investors with bonds of varying maturities in their portfolios will notice differing levels of volatility among them. As the remaining term increases, so does the volatility risk.
Kielkopf examines the average annual volatility of various U.S. government bond indices in his analysis, which reveals that these fluctuations can stem from diverse causes, such as interest rates, the risk of interest rate changes, or residual factors. The findings categorize how much of the volatility results from each factor. A notable observation is the roll-down effect, which is linked to the decreasing remaining term of a bond over time. The review period spans from late 1996 to September 2024.
In line with the principle that longer maturities lead to greater average volatility, this correlation extends to interest rate risk. One conclusion of the study is that a bond with a longer time until maturity exhibits a more pronounced risk of interest rate changes. Kielkopf emphasizes that the main source of volatility isn’t the current interest rate itself but the interest rate risk, which is the dominant factor across all maturities. For short-term bonds, this risk accounts for half of the price fluctuations, while for long-term bonds, it constitutes 75%.
Another significant insight is that indices of bonds with long maturities exhibit volatility average of 11.3% annually, comparable to equities.
What does this imply for investors? “Investors should diversify their bond holdings to spread risks,” advises Kielkopf. Combining short, medium, and long-term bonds can contribute to a more stable overall portfolio. For those without a fixed investment horizon in bonds and who prefer not to manage reinvestment of maturing bonds frequently, bond funds are suggested. Mixed funds, containing bonds of different maturities, place investors in a mid-range volatility bracket.
However, investors should scrutinize funds thoroughly. Products comprised solely of bonds with long maturities may not be suitable for investors aiming to diversify risk and maintain peace of mind. Moreover, in a volatile interest rate environment, active management might be advantageous. Professional investors employ “duration management” to respond to changing market interest rates, thus optimizing both fluctuation and return.