Why short-term bonds are a compelling investment option

Solid US economic growth, stable unemployment and sticky inflation dampen investor appetite for long-duration bonds

Bonds are used as diversifiers in a portfolio as they help reduce risk. Getty Images

A bond is a fixed-income instrument where a person lends money to a government or a company at a particular interest rate for a fixed time. The entity repays individuals with interest in addition to the original face value of the bond.

Bond yields are inversely related to bond prices, meaning if yields are up, the value of the bond declines and vice versa. This relationship between yield and prices can be further explained by duration. Duration describes how much a bond’s price will rise or fall with a change in interest rates.

Bonds are usually used as diversifiers in a portfolio as they help reduce risk during market downturns. Bonds can have varying maturity, ranging from a few months to years.

Here, we will look into short-term government bonds (one to three years) and long-term US government bonds (10 to 30 years).

Short-term bonds vs long-term bonds

Interest rate sensitivity: Short-term bonds are less affected by interest rate changes due to their shorter maturity and, hence, lower duration. As they are paid off in just a few years, they leave a very limited window for default or large price fluctuations. Therefore, these funds are considered low-risk, low-volatility instruments and are preferred by investors when they believe rates have not topped off or will stay high. On the other hand, long-term bonds are more sensitive to interest rate fluctuations and have higher duration. That’s because the longer the maturity, the higher the potential for large price fluctuations, given interest rate changes. These bonds are preferred by investors when rates are believed to have topped off and a cutting cycle will start soon.

Liquidity: Short-term bonds are generally more liquid than long-term bonds, meaning they can be bought or sold more easily. That’s because the market for short-term bonds is more active. Long-term bonds can be less liquid, especially during economic uncertainty or market volatility, as seen currently.

Some of the best performing short-term bond funds are iShares 1-3 years Treasury Bonds ETF (SHY), Schwab Short-Term US Treasury ETF (SCHO) and Vanguard Short-Term Treasury ETF (VGSH). These exchange-traded funds have large assets under management, a low expense ratio and strong overall performance. For context, the above-mentioned ETFs have given a total return of approximately 4 per cent over one year compared to -3 per cent return of the iShares 20+ Year Treasury Bond ETF (TLT).

The investment opportunity

In September 2024, the US Federal Reserve began its first rate cut in four years, bringing the target rate to 4.25 per cent to 4.5 per cent by December. The outlook for 2025 predicts stronger growth and lower unemployment. However, the inflation forecast was raised from 2.2 per cent to 2.5 per cent, higher than the Fed's target of 2 per cent.

Given the current market conditions, it is estimated that US yields are likely to stay high, within a range of 4 per cent to 4.75 per cent for the coming year, according to Morgan Stanley. With solid economic growth, a stable unemployment rate and sticky inflation expectations, enthusiasm for long-duration bonds has reduced as rate-cut expectations for the year have come down. Markets now have a wait-and-watch approach as they evaluate economic conditions and the likely impact of US President Donald Trump's policies, with around two rate cuts priced in by the markets.

Moreover, the US government is running a deficit (spending more than earnings in taxes) of almost $2 trillion and is expected to continue to do so. Hence, it would need to issue bonds to fund this deficit, a large portion of which would be long-maturity bonds (10 to 30 years). An increased supply of long-dated bonds would put downward pressure on prices and keep rates on longer-term bonds high.

Additionally, investors are asking for higher returns on long-term bonds because they want to be compensated for risks like inflation or changes in the economy over time. Moreover, it is expected that the rates on 10-year bonds could rise by about 1.3 per cent, further putting pressure on long-term bond prices.

All these factors together suggest that yields on long-term bonds are likely to stay elevated and volatile in the coming months, making short-term bonds a compelling investment option.

Moreover, investing in short-duration funds provides investors with the potential for consistent income while maintaining flexibility during uncertain times and can also help to lock in higher yields.

Vijay Valecha is chief investment officer at Century Financial