Don't Get The 'Short End' Of The Stick

by: Adam Scott

Nervous investors plowed into bonds of all shapes and sizes in 2009-10, but only over the past year or so has duration become a primary concern. Interest-rate risk is amplified the further out one goes on the yield curve-meaning, shorter-term bonds ought to have less price sensitivities in a rising interest rate environment. Pricing for longer-term bonds (those that don't mature for 20 years or more) will be more sensitive to interest rate fluctuations since the term over which they pay interest is longer.

We are seeing advice and commentary all over the financial media about shortening up the duration of fixed income portfolios. The party line goes something like this - by reducing your exposure to the long-end of the yield curve, you are taking a huge step towards protecting your fixed income portfolio against the threat of rising rates. In theory this makes good sense; but let's take a look at why it may not actually be adding much value in practice.

Time to Adjust your Risk-adjusted Return Expectations

In addition to short-term interest rates being artificially pegged near zero (the Fed Funds rate has been 0.25% since December 2008), the "shorten-duration" trade has further inflated prices (and depressed yields) in the market for these securities. My point isn't that short-term bonds are riskier than long-term-simply that there is risk in owning short-term paper, too, and the measly interest with which investors are currently rewarded is not worth taking that risk.

Duration is the measure of how much a bond fund or portfolio will rise, or fall, due to changes in interest rates. A bond fund with a duration of 2 years will lose 2% of its value when interest rates rise by 1%.

The iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) has a duration of over 16 years and currently yields 3.15%. That means you are risking five years' worth of interest should rates rise by 1%. Clearly an unattractive risk/reward-but how much better will it get by shortening our duration?

As of today investors can earn 0.34% interest by lending their money to the US Treasury for two years. As this trade has grown more and more crowded, the price of the iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY) has swelled to an all-time high, and its yield to an all-time low of 0.20%.

That's not exciting enough for you? Improve your prospective yield to 0.70% with the Vanguard Short-Term Bond ETF (NYSEARCA:BSV), which gets you exposure to short-term Corporate debt. Unfortunately BSV currently carries a duration of 2.7 years; a 1% increase in interest rates will cost you 4x your annual interest.

Do you really want to take any risk at all to earn so little? I sure don't. But according to Morningstar, this year short-term bond funds have set records for both AUM (Assets Under Management) and net inflows.

It feels like the sweeping recommendation to reduce duration is made in an attempt to keep clients' money invested in a "socially acceptable" investment allocation, by historical standards. Or perhaps it's being made by a bond fund manager, not allowed to keep too much cash and clinging dearly to his AUM (upon which his year-end bonus depends).

When it comes to squeezing yield out of risk-free or virtually risk-free fixed income vehicles, there just isn't a whole lot of meat left on that bone. If you are fortunate enough to have participated in a short-term bond fund's appreciation, you may want to reassess the level of risk you are taking - this could be a timely opportunity to hit the eject button.

Consider selling holdings like SHY and BSV before the end of the year. And if you need a tax loss to offset any gains, look no further than the longer side of your fixed income portfolio - TLT and the like. Something tells me you will have plenty of time to get back in at similar prices next month…

Disclosure: I am short TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.