Short Term vs. Intermd Term Bonds

[TromboneAl]

I'm mulling over a move from my VG short-term bond index fund (avg maturity 2.8 ) to VG Total Bond Index fund (avg maturity 7.3).

My reluctance to move away from short term is based on this, from fundadvice.com:

Whether your portfolio is heavy or light on bonds, it matters what kind of bonds you own. In general, longer bond maturities go together with higher yields and higher volatility. However, I’ve studied enough data to convince me that bonds with maturities greater than five years are not consistently more rewarding than shorter-term bonds. But they are consistently more risky.

In the 36 years under study here, the longest maturity you needed in order to achieve high bond returns was five years. All the data I have seen also indicates that one-year Treasury bills gave investors nearly 95 percent of the return of five-year Treasury notes, with much less volatility.

We believe the best combination of bond funds for stabilizing an equity portfolio – and that is why we include bonds in the Ultimate Buy-and-Hold Strategy – is a 50/50 split of bonds with maturities up to two years and those with maturities up to five years. You can find a close approximation of this mix in the typical short-term bond fund.

OTOH, in this comparison, over 10 years, the short term fund's return is only 82% as good as the total bond fund's return.

 

[brewer12345]

Al, I think it is a huge mistake to consider an asset class in isolation. I'd never invest in commodity futures in isolation, but it does a lot of good things when added to my overall portfolio. I think you should consider your choice of bond funds in the same light.

BTW, average maturity doesn't matter all that much. Pay attention to duration.

 

[Rich_by_the_Bay]

Maybe it depends on why you're holding specific bond classes.

For my near-cash, I am comfortable in short term (federal in my case) with little volatility and somewhat lower yields. This would be a big chunk for me, like 4-6 years worth of expenses.

But in the bonds I hold in my portfolio to balance stocks, I like the extended bond market for slightly higher yields and where more volatility doesn't bother me.

 

[unclemick]

Why? - central to the issue - is the function of bonds in YOUR portfolio.

One caution - bond cycle from 1981 till now may have already reversed. Soooo - that's to consider also.

heh heh heh heh - now you see why I like Target - simple - so's I can go play with my hobby stocks. Still haven't bought that kayak.

 

[wabmester]

I'm mulling over a move from my VG short-term bond index fund (avg maturity 2.8 ) to VG Total Bond Index fund (avg maturity 7.3).

Why are you mulling? Because you believe past returns predict future returns? Because you believe you can time interest rate trends? Or because you want exposure to a more diverse bond mix?

 

[d]

i certainly don't know, but have been slowly moving some $ from short-term to intermediate since the first of the year (yeah, my timing sucks)

 

[unclemick]

Will be dumping my high yield corp and short term bond soon -

Why? - absolutely nothing to do with Mr Market - the rationale for MY portfolio construction has changed pre and post Katrina.

And with the ticking of the clock - switching the withdrawal rules.

Soooo - what's the function of bonds in YOUR portfolio

heh heh heh heh - I think then it becomes easier to consider types/classes of fixed income and their characteristics.

 

[Gone4Good]

My reluctance to move away from short term is based on this, from fundadvice.com:

I'm not sure I agree with fundadvice . . . and I think your relative return chart shows why. fundadvice may be refering to a "risk adjusted return" and concluding that the extra yield of long duration bonds does not compensate for the additional volatility - and they may be right. But as brewer said, you can't look at your bond holdings in isolation but rather as part of your overall portfolio. Part of the reason to own bonds is that they tend to act countercyclical to stocks (e.g. rising interest rates are bad for bonds but usually are the result of a strong economy, which is good for stocks). The extra volatility of long-bonds help to offset some of the volatility in stocks. That is why most studies show that when added to an equity portfolio, a sliver of bonds helps reduce volatility without reducing expected returns. I doubt you get the same benefit from adding an equal amount of treasury bills.

I'd suggest averaging into the total market index fund for the same reason I hold other index funds . . . I don't have a clue which way the market is heading so I want to own a little slice of everything.

 

[IBWino]

Why not consider Vanguard's Intermediate-Term Bond Index Fund (VBIIX).  It has an average duration of 5.9 years.  I've been in this fund only a few months, but it seems to have a higher yield with volatility similar to VG Total Bond Index.

 

[ats5g]

Hi Al,

One view, like Merriman's, is that an investor should use short term bonds in a portfolio of stocks and bonds. See Bernstein's What's the Proper Bond Duration for Your Portfolio?.

However, this type of mean-variance analysis assumes that investors only care about the distribution of wealth one time period ahead [i.e. one year ahead], when what we really care about is the standard of living that our wealth can support over the long term. When one considers this, one comes to somewhat different conclusions about what types of bonds to use. See John Campbell's Who Should Buy Long-Term Bonds?:

A long-horizon analysis treats bonds very differently, and assigns them a much more important role in the optimal portfolio. For long-term investors, money market investments are not riskless because they must be rolled over at uncertain future interest rates. Just as borrowers have come to appreciate that short-term debt carries a risk of having to refinance at high rates during a financial crisis, so long-term investors must appreciate that short-term investments carry the risk of having to reinvest at low real rates in the future. For long-term investors, an inflation-indexed long-term bond is actually less risky than cash. A long-term bond does not have a stable market value in the short term, but it delivers a predictable stream of real income and thus supports a stable standard of living in the long term.

I have recently completed an empirical analysis of optimal portfolio choice for long-term investors. Using a statistical model of nominal interest rates, real interest rates, inflation, and stock prices, I have calculated optimal portfolios for long-lived investors with varying attitudes towards risk. My analysis provides qualified support for the commonsense advice of financial planners. It directs conservative long-term investors to hold more bonds and fewer equities than aggressive long-term investors. The figure illustrates this pattern. The horizontal axis shows risk aversion, with aggressive investors to the left and conservative investors at the right. The vertical axis shows the division of the optimal portfolio among stocks, nominal bonds, and cash. Aggressive investors should hold almost 100% equity portfolios, but more conservative investors should shift largely into bonds along with a very modest allocation to cash. (A larger cash position can be justified as a contingency reserve to meet unexpeced consumption needs, but I do not attempt to model this sort of cash demand.)

The conventional wisdom of financial planners comes out well from this analysis: Buyers of long-term bonds should be conservative long-term investors, or institutions such as pension funds acting on their behalf. There is however one important qualification. The analysis looks at recent historical data from the period 1983-96, during which monetary policy has successfully contained inflation. If I consider historical data from the whole postwar period 1952-96, I estimate a much larger risk of inflation that could erode the real value of long-term nominal bonds. When there is a significant risk of inflation, nominal bonds are far less appealing because they are not good substitutes for inflationindexed bonds and are not in any sense riskless for long-term investors. Conservative long-term investors who are concerned about the possible return of inflation should instead hold US Treasury inflation-indexed bonds.

Also, Jaye Jarrett wrote an article that using intermediate gov't bond [i.e. 5 yr t notes] led to higher withdrawal rates than short term or long term bonds: The Fixed Income Portion of a Retirement Withdrawal Strategy

One strategy would be to say "Hell, sometimes TIPS do better than nominal bonds, and sometimes short term bonds do better than longer term bonds, so why not just own all of them?" So, just hold:

1) ST bond [like Vanguard's ST Corp or ST index]
2) IT bonds [like Vanguard's TBM, IT index, or IT Treasury], and
3) TIPS

You could do 1/3 in each, or 1/4,1/4, + 1/2, etc. At least you'll cover your a$$ no matter what happens. And you'll probably be able to tell your spouse what a learn-ed student of portfolio theory you are.

- Alec

 

[ESRBob]

Al,
I like ats5g's approach -- find something to love about 'em all and then slice and dice. Do that for awhile and you'll end up like me with about 25 different funds in the portfolio, though!

I do like VBIIX, the intermediate term index from Vanguard, and all my fresh bond money goes there. Also agree with Brewer that duration is the key, not maturity.

 

[Rich_by_the_Bay]

Doesn't it follow that if you use bonds primarily as volatility ballast, the more stable the bond class (e.g. short > intermediate), the less of it you need in your asset allocation to achieve the same degree of stabilization.

That's my take; I'm going mostly with short term so I know it's there when I need it, but I might keep a bit less than the proverbial 50% in bonds.

 

[ESRBob]

Rich,
Not necessarily.... the stable short term bond fund has, for argument's sake, a very stable or no volatility profile. Imagine, though, if you had a bond fund that would zig when stocks zagged, and vice versa. That would do an even better job of dampening the effects of stock movements than a zero-volatility fund. Of course, finding such a 'negatively correlated' fund, and having it actually stay negatively correlated when you need it is tricky, but that's what the math tells us should be best.

For all bonds' vaunted dampening effect, my take on price history is that when interest rates rise, both stocks AND bonds get hammered. Many of these historical correlations get set from years of data, but won't always hold through every part of the cycle, or in short time frames.

 

[astromeria]

I have observed what ESRBob just described, so I gradually cashed out of bond funds over the past couple of years--just continue to hold old-standing balanced funds (OAKBX, DODBX, and VWELX) in various accounts. I use individual bonds and CDs of various terms instead. They don't zig when stocks zag, but at least I don't have to watch them sink (well, the corp bonds can sink, but it doesn't matter if held for duration--except for the queasiness factor).

 

[brewer12345]

For all bonds' vaunted dampening effect, my take on price history is that when interest rates rise, both stocks AND bonds get hammered.  Many of these historical correlations get set from years of data, but won't always hold through every part of the cycle, or in short time frames.

The point of medium to long term high grade bonds is that they end to go up in value when the economy hits the skids and rates drop. Naturally these bonds also get hit when rates (and inflation) rise, which is why a dollop of commodities helps a LOT.

 

[Rich_by_the_Bay]

Not necessarily.... the stable short term bond fund has, for argument's sake, a very stable or no volatility profile. Imagine, though, if you had a bond fund that would zig when stocks zagged, and vice versa. That would do an even better job of dampening the effects of stock movements than a zero-volatility fund. Of course, finding such a 'negatively correlated' fund, and having it actually stay negatively correlated when you need it is tricky, but that's what the math tells us should be best.

Makes good theoretic sense. When I used the ballast analogy, that's pretty much what I had in mind; not an antidote to stock price fluctuation, but rather a force to dampen the bottom line swings. Not unlike cash in the case of short-term, just with a little bit better APY (though even that gets blurred sometimes).

I had the impression that stock asset class diversification was the main way to zig and zag yields toward the mean, not so much your bonds (which were intended as above).

If there did exist a true "anti-stock" holding as you describe it, it would make for an interesting stock market: you'd never lose. Then again, you'd never win .

 

[unclemick]

In the land of ziggers versus zaggers - the great hope and some say Wall Street hype are the commodities products - along the lines of PCRIX and similar(options/fixed income).

Out of scope for this thread though.

Once in a while you see charts of intermediate Treasuries/S&P though time periods as zig/zag examples.

heh heh heh heh

 

[wabmester]

If there did exist a true "anti-stock" holding as you describe it, it would make for an interesting stock market: you'd never lose. Then again, you'd never win .

Depends on your definition of "win."   If you had two asset classes with equal average returns and equal but opposite volatility, then you'd get the average return over time with no volatility.   Seems like a win to me.   The whole idea behind MPT is to reduce volatility without reducing returns.   In theory, it's the only free lunch in investing.

The "problem" with cash is that it has zero volatility, so it dampens both overall portfolio volatility *and* returns.

 

[HFWR]

The "problem" with cash is that it has zero volatility, so it dampens both overall portfolio volatility *and* returns.

Well put...

 

[TromboneAl]

Thanks guys.

I decided to move my short-term bond money to the total bond index fund, and did it today. Note that the average duration of the total bond fund is 4.8 yrs vs. 5.9 for the intermediate bond fund.

I might have done more slicing and dicing, but I have too many different funds already.

 

[AltaRed]

I decided to move my short-term bond money to the total bond index fund, and did it today.  Note that the average duration of the total bond fund is 4.8 yrs vs. 5.9 for the intermediate bond fund.

What was the difference in current yield between total and intermediate if you have those numbers handy?

 

[saluki9]

What was the difference in current yield between total and intermediate if you have those numbers handy?

Short Term Bond Index - Current yield 5.32% Duration 2.5

Total Bond Market Index - Current Yield 5.31% Duration 4.8

I will hold my comment on what I think of that trade

 

[brewer12345]

Short Term Bond Index - Current yield 5.32%

Total Bond Market Index - Current Yield 5.31%

I will hold my comment on what I think of that trade   

Yeah, yeah. But the point isn't yield. Its total return.

 

[wabmester]

Yeah, yeah.  But the point isn't yield.  Its total return.

In a rising rate environment? OMG!!!1!

 

[saluki9]

Yeah, yeah. But the point isn't yield. Its total return.

WARNING!!! OPINIONS FOLLOW:

In my professional experience, predicting future interest rates ranks somewhere between predicting winning lottery numbers and guessing how much congress is going to spend next year

In other words, I think it's a waste of time. Therefor my best estimate of future fixed income returns are the current yield. Henceforth taking almost twice the risk for the same return doesn't rank as a wise decision in my book.

OMG I was only able to keep my opinion to myself for 16 minutes