Risk of long duration bonds

If current interest rate is 0.5% and government bonds for 10 years give a yield of 1.5%, which is better for the investor?

If interest rate remains at the low level for the next 10 years, it is better to invest in the government bonds and earn an additional 1% interest yearly. However, the risk to the investor is an increase in interest rate. If the interet rate increase to 3% per annum, the investor is stuck with 1.5% interest on the government bond for the remaining period. If the investor decides to sell the government bond at that time, there will be a capital loss of about 1.5% times the remaining period. If the remaining period is 8 years, the capital loss can be 12% (or thereabouts). The loss is higher, if the yield goes up to 5% (say).

It is difficult to predict the future interest rate. Even the the fund managers or analysts or the government leaders are not able to predict this trend. So, the investor cannot make this prediction. They should not ask other people, as nobody knows.

If you decide to invest in long term government bonds during a period of low interest rate, you should be prepared to wait out the entire period at the current yield. If you do not want to take this risk, you should invest in a bond for a short duration, say 3 to 5 years, even if you get a lower interest rate compared to long duration bonds.

Tan Kin Lian
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