Term to maturity is the remaining life of a bond or other type of debt instrument. The duration ranges between the time when the bond is issued until its maturity date when the issuer is required to redeem the bond and pay the face value of the bond to the bondholder.
During the life of the bond, the issuer is required to make coupon payments at a fixed percentage agreed on the issue date. The time of maturity can be either short-term or long-term, and each duration comes with varying interest rates. Bonds with a longer term to maturity offer a higher interest rate than short-term bonds whose term to maturity is less than five years.
Categories of Bonds Based on Terms of Maturity
Bonds can be grouped into either short-term, intermediate or long-term bonds.
1. Short-term bonds
A short-term bond is a bond with a term to maturity of between 1 to 5 years. Short-term bonds can be issued by any entity such as investment-grade corporations, government institutions, and companies rated below investment grade. They are preferred by bondholders who are looking to preserve their capital since they tend to hold up better when market conditions are unfavorable. Short-term bonds are highly liquid; investors can access their capital with ease compared to a long-term bond that tends to lock investors in for a long period.
2. Intermediate bonds
Intermediate bonds come with a term to maturity of 5 to 10 years, and they pay higher returns than short-term bonds, but lower than long-term bonds. Intermediate bonds are preferred by investors with higher risk tolerance and who expect to earn higher yields at maturity. On the downside, bonds with a longer term to maturity are more affected by price fluctuations than bonds with a short term to maturity.
3. Long-term bonds
Long-term bonds come with a term to maturity of between 10 years and 30 years. Such bonds generally pay a higher interest rate than short-term and intermediate bonds. Bond issuers are willing to pay a higher interest rate for the bonds in exchange for locking the bond for a longer period of time. Usually, the term to maturity for long term bonds may be fixed, or it can be changed during the life of the bond if the bond agreement includes a put, call, or conversion provision.
Long-term bonds are preferred by investors who are looking to maximize their returns in the long run. On the downside, the bonds lack the flexibility offered by short-term bonds. It means that, if interest rates increase, the value of the bond will decline by a similar proportion. Also, bond issuers with other outstanding bonds with shorter maturities may default on their obligations.
What Happens When Bonds Reaches Maturity
If you own bonds in your portfolio, it is important to know when they expire and the amount of time left until the maturity date. Usually, upon the expiry of a bond, the bondholder is required to return the bond certificate to the issuing entity, which is either the Federal Government or a corporation.
The issuer will then pay the original issue price or the face value of the bond to the bondholder. If the issuer did not make periodic interest payments prior to the maturity date, bondholders expect to receive the principal payment plus all the interest payments that have accrued since the bond was issued.
Bondholders are also required to pay taxes on any capital gains on the bond they hold. Typically, treasury bonds and municipal bonds may be exempted from federal and local taxes, and their holders will not be required to pay such taxes. Other bonds are subject to taxation depending on the tax laws that exist in a country.
For example, if you bought a $1,000 bond at a discount of $950, you will realize a capital gain of $50. The capital gain must be declared on your annual tax returns. If it’s a capital loss, it can help reduce the taxes due to the tax authorities.
Risk and Yield of Bonds with Different Maturity Terms
Investors can choose among short-term bonds, intermediate bonds, and long-term bonds when looking for fixed-income instruments. Their choice of investment is influenced by their risk tolerance, time frame, and objectives. Typically, short-term bonds come with low risk and low yields. They are preferred by investors whose top priority is the safety of their investments. It means they are willing to sacrifice higher yields offered by intermediate and long-term bonds to obtain greater stability and low risk.
On the other hand, long-term bonds provide higher yields and come with greater risk. Long-term bonds lock the investor’s funds for a longer period, which allows more time for interest rates to influence the price of the bond. Investors with a higher risk tolerance would willingly lock up their money for a long period in exchange for higher yields. However, long-term bonds are more than volatile than other bond types. It means that they may not be appropriate for investors who are looking to recover their investment in three years or less.