Long term bonds are bonds whose terms of maturity lie between 10 to 30 years. In comparison to intermediate bonds and short term bonds, long term bonds pay higher rates of interest. The higher rate of interest is paid against the locking-in of the bonds for a longer duration. Chiefly, the term to maturity is fixed in the long term bonds or it can change during the life of the bond as per the provisions of call, put or conversion in the agreement.
Those investors who invest in long term bonds are looking for higher returns in the long term. However, these bonds do not provide the flexibility which is extended by the short term bonds. In case the interest rate increases then the value of the bond will decline simultaneously. Moreover, the bond issuers who have issued bonds with shorter maturities might default.
The maturity terms in the long bonds are out of the investment horizon. For example, the US treasury market offers a 30 year treasury, and it is the longest term of maturity. Different maturities are offered by the corporate bonds. The maturity of the corporate bonds can range from 20 to 25 years.
The treasury long term bonds are considered as safest security which is traded actively in the trading world. In the US treasury, the yield is the amount paid by the government for borrowing money from the investors. To illustrate, a treasury bond of $10,000 is issued by the government at 2% rate of interest. The yield of the bond is $200 annually. If the investors hold the bond till maturity, then they will receive the principal amount of $10,000 by the government.
In a strong economy, long term bonds generally have normal yield curves, along with long term maturities and higher yields in comparison to short term bonds. Long term bonds extend the advantage of locked-in interest for a longer duration. However, the longevity risk is present in the bonds. When an investor invests in the long term bonds, they encounter interest rate risk as the interest rate can change in the long term and it can affect the overall returns.
Theoretically, with the increase in the interest rate, the prices of the bonds go down, because the new bonds have the potential to offer higher yields in comparison to the existing bonds. When the existing bonds are discounted for shifting to higher yield bonds, the prices of the existing bonds go down.
With the fall in the interest rate, the bonds become worthless in the secondary market and the investor would already gain fewer returns from the bonds they own presently. The prices of the long maturity bonds fall substantially than the short term bonds as more discounted payments are involved. The investors who invest in long term bonds are generally compensated with the higher yield against the longevity risk they have undertaken.
The bond market can be categorised into five parts,
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The different category of the bonds has different risk factors and its own unique characteristics. High yield bonds extend the highest yield, and they are the riskiest bonds also. Generally, the high-yield bonds offer higher yield to the investors as compensation is given to the holder against the longevity risk.
It is difficult to predict the economy and the financial market for a period of 30 years. To illustrate, the interest rate can change significantly in few years only, therefore, the yield which looks good at the time of investment might not extend the same return after 30 years. Moreover, the buying power will also reduce due to the presence of inflation. In exchange for the risk undertaken by the investors for a longer duration, they demand higher yields. In any category, a 30 year bond usually pays higher returns than short term bonds.
The important concept in the field of interest rate and bond prices is that there is an inverse relationship between the interest rate and the value of the bond. With the increase in the rate of interest, the prices of the bonds decrease and vice versa also holds true.
The long term bonds are exposed to a high amount of interest rate risk because of the two main reasons: