Article by Colin Attard
Several bond issuers, including governments and large corporates, frequently issue different bond tranches spanning the maturity spectrum. Rightly so, investors frequently ask whether they should buy bonds of a longer maturity in search for higher coupons and yields. Sometimes the choice is relatively marginal, for example, choosing between a 5 year and 7 year bond, but in some cases investors need to choose between bond maturities which are vastly different. Such a decision should not be taken lightly and is indeed one of the most important decisions bond investors face.
Longer-maturity bonds generally offer higher yields than shorter-term bonds. Investors demand additional compensation for committing their capital for longer periods, reflecting the greater uncertainty surrounding inflation, economic growth and future interest rates. This additional compensation is commonly referred to as the term premium. However, a higher yield should never be viewed in isolation. Longer-dated bonds also expose investors to greater price volatility. While the additional income may appear attractive, it comes with an increased risk that the bond's market value could fluctuate significantly if interest rates change.
Rather than focusing solely on the highest available yield, investors should consider whether the additional return adequately compensates them for the additional risks they are assuming. Bond prices move inversely to interest rates. When market yields rise, existing bond prices fall, while declining yields cause bond prices to increase. The longer a bond's maturity, the greater its sensitivity to changes in interest rates. This sensitivity is measured by duration. A bond with a higher duration will experience larger price movements for the same change in market yields than a bond with a shorter duration. For example, a long-term bond could decline significantly in value during a period of rising interest rates, whereas a short-term bond would typically experience a much smaller decline. Conversely, investors expecting interest rates to fall may benefit more from holding longer-duration bonds when yields do fall, which would tend to generate larger capital gains.
A bond's maturity should also be consistent with an investor's investment horizon. Investors who expect to need their capital in the near future may be better served by shorter-maturity bonds. These securities reduce exposure to market fluctuations and return principal sooner, allowing investors to reinvest or use the proceeds when required. By contrast, investors with long-term objectives may be comfortable locking in yields for longer periods, particularly if they have no immediate need for the invested capital.
Holding a bond until maturity largely eliminates concerns about interim price fluctuations, provided the issuer doesn’t default. However, investors who may need to sell before maturity should recognise that longer-term bonds carry greater market risk. Matching bond maturities to future financial commitments is therefore important.
Although accurately forecasting economic conditions is difficult, investors' expectations regarding inflation and monetary policy often influence maturity selection. If inflation is expected to remain low and central banks are likely to reduce policy interest rates, longer-term bonds may offer attractive capital appreciation potential. Falling market yields increase the value of existing bonds, with longer maturities benefiting the most. Conversely, if inflation remains persistent or governments continue to issue large amounts of debt, long-term yields may continue rising. In such an environment, shorter-maturity bonds generally perform better because their prices are less sensitive to increases in interest rates. Rather than attempting to make aggressive market forecasts, many investors choose to diversify across several maturities to reduce the risk of being positioned incorrectly.
Income needs should also influence maturity decisions. Longer-term bonds often provide higher coupon income and allow investors to lock in attractive yields for extended periods. This can be particularly valuable for retirees or institutions seeking predictable cash flows over many years. Shorter-term bonds, however, expose investors to reinvestment risk. When a bond matures, the proceeds must be reinvested, potentially at lower interest rates if market yields have declined. Longer maturities reduce this reinvestment risk by locking in current yields for a longer period, although they simultaneously increase exposure to changes in market prices.
Inflation erodes the purchasing power of fixed coupon payments. The further into the future those payments are received, the greater the uncertainty surrounding their real value. This makes long-term bonds more vulnerable to unexpected increases in inflation. Rising inflation expectations typically push long-term yields higher, resulting in larger price declines for longer-duration bonds. Investors concerned about inflation may prefer shorter maturities or consider inflation-linked bonds, which adjust principal or coupon payments to reflect changes in inflation.
Investors should also consider the shape of the yield curve, which shows yields across different maturities. A steep yield curve indicates that longer maturities offer substantially higher yields than shorter ones, potentially providing attractive compensation for extending maturity. Conversely, a flat or inverted yield curve suggests that investors receive relatively little additional yield for taking considerably greater duration risk. In these environments, remaining in shorter maturities may offer a more favourable risk-adjusted return.
No single maturity is appropriate for every investor or every market environment. A financial advisor or portfolio manager seeks to consider all these factors when recommending bonds to clients or constructing investment portfolios. Generally, a well-balanced portfolio often combines multiple maturities, ensuring that investors are not overly exposed to any single economic outcome while remaining aligned with their long-term financial objectives.
Colin Attard is Chief Investment Officer at Curmi & Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd, with registered address Finance House, Princess Elizabeth Street, Ta Xbiex, Malta XBX 1102, is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.