Yield Curve - Should you buy short-term, medium-term or long-term bonds


August 22, 2011

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An important concept for you to grasp as a first-time bond investor is the yield curve. In most economic climates, the longer you are willing to tie up your money, the higher the yield you can earn [for more municipal bond analysis create a free account].

This is similar to a car loan or home loan: If you want to borrow money for 2 years, the annual rate you will pay will be lower than if you wanted to borrow money for 10 years. As a lender, which is what you are as a bondholder, you will generally get the benefit of higher yields with longer maturities. For instance, as of the end of 2012, the U.S. Treasury yield curve is as follows:

1 Year: 0.18%

2 Year: 0.25%

3 Year: 0.34%

5 Year: 0.63%

7 Year: 1.05%

10 Year: 1.63%

20 Year: 2.37%

30 Year: 2.80%

The yield curve is basically just a visual representation of the concept that the longer you tie your money up, the higher your yield. There are temporary periods where the yield curve becomes inverted when short-term rates are higher than long-term rates.

When you are buying your first bond or assembling a portfolio of bonds, you will need to determine when you need access to the principal, how much ongoing interest you need to receive, what yields you find attractive, where you think interest rates may be in the future, how much inflation is there likely to be, and even how your personal tax bracket may change. These answers will help you select the right maturity years for your portfolio.

It should be noted that the right bonds for you may not be right for someone else. Having a strong understanding of your personal circumstances and needs is the key to building a good bond portfolio. Bond investing does not need to be complicated and you shouldn’t overthink it. If you buy good quality bonds, you are going to get your principal back at maturity. Once you are comfortable that your capital has adequate protection in terms of quality, the only real issue is to get an acceptable yield on your portfolio given your time horizon.

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