Are Your Bond Holdings Too Short?
Don’t shun longer-term bonds entirely. Our suggestion to keep average portfolio duration in the short-to-intermediate range doesn’t mean abandoning long-term bonds altogether.
Intermediate and long-term bonds can help provide diversification from stocks during downturns and generate income.
Timing the moves in interest rates is difficult. Matching the maturities of your bonds with when the money is needed can help smooth out the ups and downs of the market and avoid bad timing.
A Day Late and a Dollar Short?
For the past two years, we’ve been suggesting that investors keep the average duration in their fixed income portfolios in the short-to-intermediate term (approximately two to five years, depending on the types of bonds). Our reasoning was simple: With the Federal Reserve raising short-term interest rates and paring its bond holdings, the path of least resistance for yields was higher. Since bond prices tend to fall when interest rates rise, it makes sense to limit exposure to longer term bonds that tend to be the most sensitive to changes in interest rates.
However, lately it looks like investors may have gone too far in the direction of shortening duration, favoring Treasury bills (T-bills) and certificates of deposit (CDs) maturing in six months or less. We favor a lower average duration than usual while rates are rising; we don’t think investors should necessarily abandon intermediate and long-term bonds entirely. There are good reasons that investors may want to have some allocation to longer-term bonds. Here are three:
1. Treasury bonds are better than cash for diversification from stocks.
Long-term Treasuries have historically been one of the best asset classes to provide diversification from stocks. While short-term Treasuries or other bonds may hold their value during stock market declines, Treasuries with intermediate- or long-term maturities actually tend to appreciate in value. The appreciation can prevent the value of an overall portfolio from falling too sharply during equity bear markets. If an investor needs to tap into the portfolio during an equity bear market, there will be assets that have appreciated in value.
Intermediate-term bonds have tended to outperform T-bills when stocks are down 20% or more
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Indexes used are the S&P 500 Index (stocks), Ibbotson Intermediate-Term Government Bond Index (bonds), and the Ibbotson US 30 Day Treasury Bill Index. Total returns reflect the trailing 12-month total return, ending the month shown on the horizontal axis. Total returns include price change and interest or dividend income. Past performance is no guarantee of future results
Going as far back as the 1930s, we found that during periods when stocks declined by roughly 20% or more, returns for short- and intermediate-term Treasuries were positive. With the exception of the 1970s, when inflation and inflation expectations were very high, intermediate-term bonds outperformed T-bills and provided a buffer in portfolios with equities in most cycles.
2. Short-term investments don’t replace bonds in a financial plan.
Cash has a place in a portfolio. We believe investors should hold enough money in short-term, liquid assets to meet their immediate needs—perhaps 12 months’ worth. For retirees, holding the equivalent of three years of spending needs in relatively low-risk, short-term investments may be needed.
For the rest of the portfolio, we often suggest that investors consider when they will need the money. For money you expect to need in the short term, we think that T-bills, CDs and/or money market funds are probably suitable. However, if your time horizon is more than one year, then it probably makes sense to invest that money over a longer time period.
In our view, the risk/reward currently looks the most attractive in the two- to five-year region of the Treasury yield curve, because that is where the curve is the steepest. The yield difference between three-month T-bills and five-year Treasury notes is about 85 basis points: Five-year Treasuries offer a yield of roughly 2.8%, compared with a yield of just under 2% for 3 month T-bills (a basis point is equal to one one-hundredth of a percentage point, so 85 basis points is the same as 0.85% ). That’s about 17 basis points in income for every incremental year of added duration. In contrast, the yield difference between five- and 10-year bonds is only around 10 basis points total, or about two basis points in additional yield per year. That’s not much compensation for the added risk of volatility in longer-term bonds.
Higher short-term yields mean less yield chasing
Source: Bloomberg, data as of 8/3/2018. Past performance is no guarantee of future results.
An investor could achieve that five-year average duration by constructing a portfolio of short-term investments, some intermediate-term bonds and some long-term bonds. Investors who use a fund that tracks the Bloomberg Barclays Aggregate Bond Index for their core bond holding should be aware that the duration of the index has increased over the years. At over six years, the duration is longer than our suggested two- to five-year range and could result in heightened volatility. We suggest adding some short-term investments such as T-bills or CDs to reduce the average duration of your portfolio and mitigate the potential for price declines if interest rates rise further.
The average duration of the U.S. Aggregate index is above our preferred maturity range
Note: Duration measures a fixed-income investment’s sensitivity to changes in interest rates.
Source: Bloomberg Barclays. Monthly data as of 7/31/2018.
3. Timing the interest rate cycle is tough
If all of your allocation to fixed income is in very short-term maturities, then you’re essentially attempting to time the interest rate market, which is notoriously difficult to do. There is a risk that by avoiding longer-term bonds, you miss the opportunity to add income to your portfolio by waiting for the peak in interest rates for the cycle.
We are anticipating a peak in 10-year Treasury yields in the 3.25% region for this cycle, based on the current outlook. Historically the peak level in 10-year Treasuries has tended to coincide with the peak level of the federal funds rate. Based on its most recent projections, the Fed anticipates raising short-term rates to the 3.25% to 3.5% level over the next few years. However, those projections can change as the economic outlook changes. Consequently, waiting for evidence of a peak in yields can mean missing out on the opportunity to earn income from intermediate- to long-term bonds.
The longer the Fed tightening cycle lasts, the more likely it is that long-term bonds will start to outperform short-term bonds. That’s because tighter policy usually leads to a slower pace of economic growth and lower inflation in the longer run—factors that affect long-term bond prices. Moreover, inflation has remained low over the past few years despite the Fed’s efforts to push it higher.
Core PCE has been below 2% since early 2012
Source: Bloomberg. U.S. Personal Consumption Expenditure Core Price Index, year over year, seasonally adjusted. Monthly data as of 6/30/2018.
Less fear, more income
Although we see the potential for interest rates to rise for all maturities, we believe investors should not shun intermediate-term or even long-term bonds entirely. A strategy like a bond ladder with an average duration in the two- to five-year region can be a good way to provide more income, diversification from stocks and to get out of the business of trying to time the market.