Short- and intermediate-term bonds funds share many similarities. One of the key characteristics of bond funds in general is that they spread out investment risk among many different bonds, reducing overall investment risk. However, short- and intermediate-term bond funds do generally vary in how they react to interest rates and in the amount of income they generate. Which type of fund is more appropriate for you depends on your investment goals and the specific characteristics of each individual fund.
The primary reason to invest in most bond funds is to generate income. Bonds are not generally designed to generate capital gains, as they are essentially loans that pay you interest. The longer the maturity of a bond, the more likely it is to pay a higher interest rate, all other things being equal. As a result, most intermediate-term bond funds pay a higher interest rate than similar short-term bond funds. If income is your objective, an intermediate-term bond fund may be more appropriate for you.
Interest Rate Risk
When market interest rates go up, the price of existing bonds goes down. This phenomenon is known as interest rate risk. The longer the maturity of the bond, the more susceptible it is to a price drop when rates move up. This translates into a higher interest rate risk for intermediate-term bond funds than for their short-term counterparts. In exchange for the potential for higher income, an intermediate-term fund has a greater risk of the loss of your invested capital.
In a short-term bond fund, bonds mature quite frequently. The portfolio manager can take the proceeds of maturing bonds and reinvest them in bonds at the current market interest rate. As a result, short-term bond funds can adapt to rising interest rates more rapidly than intermediate-term funds. If rates move higher, the yield that a short-term fund pays you will rise more rapidly than an intermediate-term fund. However, the opposite is also true. When rates are falling, a short-term fund's yield may fall more rapidly than that of an intermediate-term fund.
A bond's promise to pay is only as good as the financial strength of the company issuing that bond. If a company can't afford to pay the interest or principal on its bonds, your bond fund may end up suffering a loss. To help you make a choice about the type of bonds you want to invest in, most funds publish an average bond quality rating, with AAA being the highest rating. The lower the rating, the higher the risk for bond defaults. Both short- and intermediate-term bond funds can carry high or low ratings, although the longer maturity of intermediate-term bonds increases the time the individual bonds have to default.
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