Evaluating Interest-Rate Risk

As a bond investor, the next most important thing you want to know after who's got your money is how long they have it for. The longer the term of the bond -- the longer its maturity (e.g. two-year, 30-year) -- the more interest-rate risk it carries. (For a definition of interest-rate risk, see an earlier piece.)

That means that a given change in yield will produce a larger price movement on a longer-term bond. If, for example, the yield on the two-year note and the 30-year bond both rise by 0.01%, the price of the 30-year will fall farther than the price of the two-year.

That's because the 30-year pays a higher coupon to compensate investors for tying up their money for a longer time period. To get the same yield change, the price on the higher-coupon bond has to fall further.

Same goes for bond fund shares: Long-term funds generally yield more (their collective dividend divided by their share price is higher), but their net asset values (the prices of the bonds in the portfolio divided by the number of shares) jump around more than those of short-term funds.

Compare, for example, the price changes of two Vanguard Treasury bond funds, a short-term fund and a long-term fund, on the first days of 1994, 1995 and 1996 (1994 was one of the worst years ever for the bond market, while 1995 was one of the best).

The (VFISX)Vanguard Short-Term U.S. Treasury fund's share price was $10.37 on Jan. 3, 1994, $9.78 on Jan. 3, 1995, and $10.32 on Jan. 2, 1996. The (VUSTX)Vanguard Long-Term U.S. Treasury fund, on the other hand, saw its share price go from $10.49 on Jan. 3, 1994, to $9.01 on Jan. 3, 1995, and then back up to $10.77 on Jan. 2, 1996. The long-term fund's NAV moved more than twice as much as the short-term's.

So which do you buy when? If you're looking for a short-term investment, go with the short-term fund. But if you're thinking longer-term, the short-term price fluctuation won't matter as much, so you should go for the yield that a longer-term fund offers.

Here's a caveat: Historically, you've been able to capture most of the benefit of the higher yields offered by longer-term bonds by buying ones that mature within 10 years -- or by buying an intermediate bond fund -- with much less volatility.

So you can argue, and many investment advisers do, that there's no sense in taking on the added interest-rate risk that long-term bonds and bond funds carry. Bottom line: Over the long term, long-term bonds have put up bigger numbers than intermediate bonds, but not that much bigger. You need to decide if that extra bit of return is worth the considerable extra risk you'd have to assume.

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