3 Reasons To Boost Short-Term Allocation

by: John Tobey, CFA

For many investors, the past few years have proven that intermediate- to long-term bonds are a great place to invest. Short-term bonds and money market securities have seemingly played the role of spoiler, offering no clear benefits and dragging down overall returns. Hence, there's been an understandable allocation reduction.

The best example is money market securities, the obvious loser. Their yield been near 0%, and they've had none of bonds' price gains. So, why on earth would we want to put assets into such a poor investment?

Let's start with the data we know. Performance results show how inferior short-term bonds and, particularly, money market funds (MMFs) have been. Negative MMF flows show the widespread investor decision to invest elsewhere.

Barclays UST ETFsClick to enlarge

(Stock chart courtesy of StockCharts.com)

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(Data source: Federal Reserve Bank of St. Louis - FRED)

However, there is a problem relying on that data. Yesterday's results are untrustworthy when deciding how to invest for tomorrow. Successful investing requires looking ahead - particularly, six months out (the dividing line between fact-based forecasts and arm-chair visualizations). What we see now is a shifting landscape that could favor short-term bonds and money market securities. Here are the three reasons why:

First, CPI inflation looks ready to rise. This forecast is for both the total CPI and the Fed's preferred ex-food and energy one. The reason? Housing prices (ownership and rental) now are increasing steadily and significantly. Once ignited, housing trends tend to be long lasting, so this large component in the CPI calculations could be an inexorable force going forward.

Now, consider the Fed's 2% inflation line-in-the-sand. With the current rate close to that trip wire, it wouldn't take much to cross it. Doing so would be a strong impetus to raise rates (or, at least, let them rise naturally from their ultra-low levels). This Fed action could occur even prior to the 2% level being breached. According to the Fed's meeting minutes, the discussion has already begun. (That 6.5% unemployment goal? Expect it to be easily overridden by inflation concerns.)

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(Data source: Federal Reserve Bank of St. Louis - FRED)

Second, even at current inflation levels, bond yields are too low. The cause is the lengthy, four-year Fed policy of ever-lower interest rates. This policy systematically lowered investors' views of what was an acceptable, long-term interest rate. Yields that would have been viewed as undesirable two years ago are now considered satisfactory today.

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(Data source: Federal Reserve Bank of St. Louis - FRED)

Analyzed objectively, yields are too low. The clearest proof is what has happened to Treasury Inflation Protected Securities (OTC:TIPS), where 2012's move to negative yields means investors now invest knowing that, for ten years, they will earn a negative real return ("real" means adjusted for inflation and risk). Moreover, TIPS aren't alone. All bonds (U.S. Treasury, government and corporate, including high yield) are linked to one another, so negative real return pricing is everywhere.

Third, the U.S. economic, financial and corporate situation is shifting away from monetary largesse. We are losing the boost we've had for the past four years. Congress now is focused on dealing with the Great Recession's recuperative program deficits. While we don't know what congress' eventual resolution will be, we can be certain that it will be a step towards normality. In place of supportive efforts and stimulus spending, congress will focus on encouraging progress while balancing finances. What this means to us investors is that the wind at the markets' backs from those easy money/stimulus programs is gone.

A special note about how the benefits of MMFs can outweigh bonds

MMFs are not anemic bond funds. There are two key differences where MMFs outshine and can produce superior returns.

First, MMFs adjust to interest rate trends quickly. With very short-term holdings, the portfolio continually rolls over. This mature-reinvest cycle allows the portfolio to track short-term interest rates in short order. Too often, though, that characteristic is ignored, with simple yield comparisons being used to make investment decisions. Here is an example:

In the period 1978-1982, I conducted the asset allocation studies for the pension consulting firm, Callan Associates. This was a rough period for both stocks and bonds, with inflation and interest rates reaching double digit levels. The yield curve had inverted, putting money market rates above bond yields. At every board presentation I made, at least one board member had a sheaf of papers showing that money market investments were the best way to invest the entire fund. The data was past returns and current yield comparisons. To educate those boards and get them to allocate properly, I explained how, for example, a 10-year U.S. Treasury bond yield of 12.8% (Dec-1980) wasn't inferior to a 1-year U.S. T-bill yield of 14.9%. Locking in that 12.8% might seem like giving up an easy 2.1%, but we wouldn't know the true comparison until the 10 years had passed, and the T-bills had been rolled ten times. (The final T-bill return through December 1990 was 9.3%, well below the initial 14.9% rate as well as the 12.8% 10-year bond yield.)

Today, we have the opposite case, where we need to understand that a MMF yield of 0% is not inferior to a 10-year U.S. Treasury bond yield of 2%. Does that bond lock up the 2% difference? We won't know the answer until that MMF's portfolio is rolled many times during the next 10 years. Could the MMF 10-year average return be greater than the bond's 2% yield? Definitely.

Regardless of the eventual return comparison, the important point is that a money market portfolio adjusts quickly to rate changes, whether from Fed actions, inflation changes or the economy's financial soundness and needs. Therefore, investing in MMFs means we are covered for the risk that bond rates could rise and prices could fall.

Second, MMFs offer liquidity without price risk. The MMF structure ensures we can get in and out at $1.00 per share, taking no price risk, even if rates were to jump quickly. A bond fund, while easily salable, doesn't offer that price protection. Rate increases cause bond prices to fall. Importantly, with bond yields so low, it doesn't take much of a rate increase to wipe out the minimal income. For example, here is the one-year return/risk picture for a 10-year 2% UST bond purchased at a 2% yield. The small $20 interest received (from a $1,000 bond) covers only a 0.25% interest rate rise's effect on the bond price. Anything greater than that results in a negative return. Plus, if the MMF yield rises, the comparison becomes even less favorable for the bond.

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Therefore, MMFs provide a counterbalance to bond price risk.

The bottom line

Boosting the allocation of short-term bonds and money market securities looks desirable now. For the three reasons cited above, we could be near a watershed moment when the forces that pushed bond yields ever lower and prices ever higher begin to reverse. And that means bond risk (yield rise = price decline) may soon show itself.

With shortened maturities, we can more quickly reinvest in higher yields as well as take advantage of other opportunities that could occur in the new environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Positions held: 100% cash reserves