Short-term bonds in 2022 offered better yields than longer-term bonds. That’s an exception to the historical pattern of longer-term bonds typically offering a higher interest rate than shorter-term bonds. Investors responded to this temporary role reversal by piling into one-, two- and three-year securities. Nevertheless, there are compelling reasons not to put all your financial eggs in a short-term basket and instead to start extending the maturities of your fixed-income securities, according to Charles Schwab. Consider working with a financial advisor as you strike a balance between short-term, intermediate-term and long-term bonds.
The Current Strength of Short-Term Bonds
The Federal Reserve has been raising its federal funds rate throughout 2022 to tamp down inflation, which has been running at a 40-year high. By October, for example, six-month Treasury yields were about the same as a 20-year Treasury.
“As the Fed increases rates, short-term rates are very likely to move higher as well,” Schwab says. “However, longer-term bonds, like the 10-year Treasury, are less influenced by the fed funds rate. Instead, yields for longer-term bonds tend to be more closely tied to prospects for inflation and economic growth.”
The upshot in 2022 has been short-term bond rates exceeding long-term bond rates. But that is not expected to continue. Wall Street anticipates the U.S. central bank to cut rates later in 2023. When that happens the yields on short-term fixed-income securities are expected to fall beneath yields on longer-term fixed-income securities. At that point, investors will need to have prepared for reinvestment risk.
Reinvestment rate risk is the chance that an investment will produce lower than expected income due to a future drop in interest rates. This risk is most closely associated with fixed-income investments, especially callable bonds. Shorter-term bonds also tend to have a higher reinvestment rate risk than long-term bonds. This occurs when an investor must reinvest funds as a lower-than-anticipated rate in the future due to falling rates.
Reinvestment rate risk is especially relevant with callable bonds. These are bonds that the issuer has reserved the right to redeem before the maturity date by paying bondholders the securities’ par value, also called the face value.
When a bond is called, the investor receives the face value of the bond but then must find a new place to invest it. If interest rates have declined since the investor purchased the bond, it may be difficult to find a bond of similar qualify that pays a similarly high rate of interest. This change of having to accept a lower rate of return is reinvestment rate risk.
Two Remedies for Reinvestment Risk
One way to cut reinvestment risk is with what’s called a barbell. Another way is with a ladder strategy.
This tactic focuses on investing in both high-risk assets (seven to 10 years) and low-risk or no-risk assets three years or less). The goal is to strike a balance between these two extreme positions but avoid adding any medium-risk assets to the mix. One goal of this strategy is to lock in yields.
“The 10-year Treasury is expected to fall to 3.2% in the fourth quarter of 2024, from its current level of roughly 4%,” says Schwab. “Yields for short-term Treasuries, on the other hand, face elevated reinvestment risk given the potential for the Fed to cut rates in the near term.”
The historical pattern is longer-term bonds have outperformed after the Fed was done hiking rates.
A bond ladder is a strategy that aims to mitigate interest rate risk and manage cash flow.
- Smooths the effect of interest rate fluctuations. When you stagger points of maturity, you can avoid getting locked into a single interest rate for several years. As different bonds mature, you can adjust your investments based on the market. If interest rates have increased, you can reinvest at higher rates. If rates have fallen, you still have some bonds locked in for the longer term at a higher rate. Laddering also offers protection against inflation, which diminishes the value of fixed payment returns.
- Helps steady your income stream. Unlike other investments, bond ladder proceeds are incredibly predictable. You know that you’ll receive your principal upon bond maturation, as well as the amount and date of coupon payments you will earn along the way. That consistency makes it easier to design a budget and prevents you from dipping into your savings unexpectedly or unnecessarily.
It’s perfectly understandable why investors would pile into short-term bonds since they are offering a higher annual percentage yield than longer-term bonds. But this relatively anomalous inversion may be short lived given market projections that the Fed will cut the federal funds rate in late 2023. And if that’s the case fixed-income investors should consider fortifying their portfolio against reinvestment rate risk with a ladder and a barbell.
Tips on Investing
- A financial advisor can help you balance risk and reward in the fixed-income portion of your portfolio. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use our no-cost inflation calculator to help you determine the buying power of a dollar over time in the U.S.
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