Investing in short-term bonds involves holding until maturity to earn interest, while long-term bonds, influenced by interest rate changes, offer opportunities for profit through buying low and selling high.
With the unprecedented rapid rate hikes by the Federal Reserve and ongoing inflation threats, the financial markets are undergoing systemic changes. This shift may persist for an extended period, significantly boosting bond yields, making them more appealing compared to stocks. The upcoming year 2024 is dubbed by many as the "year of the bond resurgence," and if you haven't yet delved into bond investments, it might be challenging to secure sustained and substantial returns.
To facilitate understanding, let's briefly introduce basic knowledge and strategies for bond investment, especially for novice investors.
How to Invest in U.S. Short-Term Bonds?
For bond beginners, starting with Treasury Bills (T-Bills) is recommended. T-Bills are short-term U.S. government bonds with maturities ranging from 1 month to 1 year. Short-term bonds follow a "buy and hold until maturity" strategy, meaning you purchase and hold them without further action, earning returns through bond interest.
However, investing in T-Bills comes with reinvestment risk due to their short-term nature. As interest is influenced by the Federal Reserve's monetary policies, future yields might decline. Overall, T-Bills are suitable for investors with surplus cash, a low-risk tolerance in the short term, and a preference for fixed income.
Ways to invest in T-Bills include purchasing through a broker, directly on the Treasury Department's website (limited to U.S. residents), or investing in T-Bill ETFs, such as iShares' SGOV.
Short-term bond ETFs are a recommended investment for beginners. Compared to buying individual bonds, this method has a lower entry threshold and eliminates the hassle of manual repurchases. Opting for an ETF allows automatic interest collection following the T-Bill cycle. While ETFs may incur additional management fees, they are generally below 0.1%. Taking SGOV as an example, it invests in T-Bills with a maturity of 90 days, maintaining a price of $100, paying interest monthly. Note that the interest is variable, calculated based on the prevailing T-Bill rates at maturity. Currently, SGOV's yield is 5.39%, with a 0.07% management fee.
If short-term bond investment is a risk-free passive strategy, long-term bond investment involves some risk and complexity, offering higher profit potential.
How to Invest in U.S. Long-Term Bonds?
U.S. long-term bonds typically refer to bonds with maturities exceeding 10 years. Unlike short-term bonds, the returns from long-term bonds mainly depend on bond price changes. During interest rate reduction periods, long-term bond prices may rise, offering increased profit potential.
The strategy for long-term bonds is buying low and selling high without holding until maturity. Judging when to buy or sell depends on the trend of long-term interest rates. Given the Federal Reserve's imminent end to the rate-hiking cycle and a possible entry into a rate-cutting cycle, long-term bond investment is gaining more attention.
Understanding the yield potential and risks of long-term bonds relies on the concept of duration, measuring the sensitivity of bond prices to interest rate changes. Larger durations in long-term bonds indicate higher sensitivity to interest rate fluctuations. While long-term bonds offer significant yield potential and operational flexibility, they come with increased risks.
To simplify operations, retail investors are advised to choose long-term bond ETFs, such as TLT. This allows participation in the long-term bond market through simple ETF trading, avoiding liquidity issues and the complexity of bond selection.
Examples:
Suppose I spent $1,000 on a 4% annualized yield, 10-year U.S. Treasury bond. One year later, market interest rates drop to 1%. The question arises: at what price can I sell the bond I purchased?
Firstly, it's essential to clarify a common misconception: many believe that when market interest rates change, the interest on bonds held will also adjust. However, the interest is fixed from the moment of purchase. For instance, if I bought a 4% annualized yield, 10-year U.S. Treasury bond, even if market rates drop to 1%, I still receive 4% annually, i.e., $40 in interest. Despite market rates falling to 1%, new bonds issued would only yield $10 annually. In this scenario, my bond is evidently more valuable than newly issued bonds. Consequently, if I intend to sell this bond in the market, its price will be higher than $1,000. It is evident that when market rates drop from 4% to 1%, bond prices rise.
In another example, assuming I spent $1,000 on a 4%, 10-year U.S. Treasury bond, and one year later, market rates rise to 6%. In this case, new bonds issued would yield more interest than the one I initially held. My bond becomes less attractive, possibly requiring a discounted sale if I want to sell it. Thus, when rates rise, bond prices naturally fall.
Understanding the impact of interest rate risk on bond prices for long-term bonds paves the way for strategies to profit from them. Unlike short-term bond investment, which relies on collecting interest, long-term bond investments involve making profits through price differences.
The specific operation involves not necessarily holding until maturity but rather buying low and selling high during the process. The key is to judge the trend of long-term interest rates. If rates drop, purchasing long-term bonds in anticipation of rising bond prices is viable. If rates rise, selling long-term bonds is a strategy to benefit from falling prices.
Currently, as the Federal Reserve's rate-hiking cycle is nearing its end, although the timing of rate cuts remains uncertain, a rate-cutting cycle is inevitable. In a rate-cutting cycle, long-term bond prices will correspondingly rise. This forms the fundamental logic for the current strategic positioning in long-term bonds.
Recently, there has been a shift in the Federal Reserve's policy stance, and long-term interest rates have declined from 5% to 3.9%. Correspondingly, the stock prices of long-term bond ETFs (such as TLT) have risen by nearly 20% during this period, outperforming even stocks.
Although we understand the inverse correlation between bond prices and interest rates, it's crucial to quantify how much price change interest rate movements will bring. Fortunately, we have a specific indicator for this purpose: duration. Duration measures the sensitivity of bond values to interest rate changes.
Taking TLT as an example, its duration is approximately 17. This means that a 1% drop in interest rates will cause the price of TLT, a long-term government bond ETF, to rise by 17%. Conversely, if interest rates rise by 1%, TLT's price will also fall by 17%.
With this indicator, we can quantitatively assess the potential for returns and associated risks. An essential property of duration is that the longer the bond duration, the greater its sensitivity to interest rates. For example, short-term bonds (like T-Bill) have short durations, usually less than 1, far lower than the value of 17 for a 20-year U.S. Treasury bond ETF (such as TLT).
If you wish to enhance income potential, you can opt for longer-term government bonds. However, if you are more concerned about risk, you may choose government bonds with slightly shorter maturities.
In addition to the increase in market value, another advantage of long-term bonds is the provision of a substantial risk-free interest rate. While the returns offered by the risk-free interest rate may not be as enticing as market value fluctuations, it still serves as a decent supplement. In summary, investing in long-term bonds involves elevating income potential and exercising control over risks.
The advantages and disadvantages of long-term and short-term bond investments complement each other:
Short-term bonds are suitable for investors who anticipate rising interest rates and seek relatively stable returns, while long-term bonds are suitable for those expecting interest rate declines and pursuing higher potential returns. To strike a balance between stability and potential returns, some investors choose to simultaneously invest in both short and long-term bonds, employing an immunization strategy.
In summary, bond investment is a relatively prudent choice for individual investors. By gaining a basic understanding and making informed choices, investors can participate in the bond market, secure fixed income, and simultaneously mitigate certain risks.
To facilitate your selection, I've compiled a list of the most common U.S. bond ETFs available in the market.
In conclusion:
Invest in short-term T-Bills, hold until maturity, and earn interest.
Invest in long-term bonds, capitalize on interest rate fluctuations, and profit from buying low and selling high.
Combining short and long-term bonds creates a complementary and more balanced investment strategy.
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