The Pain Of Being Short Duration - A Guide To What Holding Short-Maturity Bonds May Have Cost You Over The Last Few Years

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Includes: IEF, IEI, SHV, SHY, TLH, TLT
by: Matthew Salter, CFA

Summary

With yields at record lows at the end of 2008 many commentators thought the only direction they could go was up.

Consensus advice was to forego potential extra returns from long maturity bonds because of the potential large losses from higher yields.

Those brave enough to ignore that advice profited handsomely, those who followed the consensus were rewarded with meager returns.

Introduction

Ever since government bond yields plummeted in the final days of 2008 at the depth of the global financial crisis, a warning went up from investment gurus to move away from long duration bonds to the 'short end' of the curve. The thinking was that yields were so low that they would inevitably go up, and as rising yields create the greatest losses in longer maturity bonds, investors were advised to hold short maturity bonds.

Lots of people listened. Which was good advice in 2009. But then they stuck with that advice and have paid dearly since.

This article looks at the returns from being invested in different parts of the yield curve over the last few years and shows how the fear of rising yields prevented many investors from making outsized profits.

Background

I work with a wise colleague who has argued for the last few years that he preferred to be invested short duration with low returns and to be able to sleep at night, rather than take the extra small amount of return from going long duration as he would have to lie awake at night worrying about the market risk if yields go up.

Personally, I don't have a problem sleeping at night, even if World War Three was raging outside my bedroom window. But I was curious as to how much investors had sacrificed from being low duration - or put another way - how much they have been paying up in order to sleep at night these last few years.

This article is a guide to answering that question.

Quick bonds lesson

Quick bonds lesson for non-seasoned investors. Duration refers to the interest-rate risk of a bond and is closely tied to the maturity of a bond. So short maturity bonds, such as 2-year bonds, will in the vast majority of cases, have a lower duration that longer maturity bonds, such as 10-year bonds.

What the duration signifies is the percentage change in price of a bond given a change in yields. So if the "fear" in the investment world is that yields are going to go up, then longer duration bonds will have a greater loss than shorter duration bonds.

This was indeed the fear or view from many market commentators in the wake of the financial crash of 2008. Yields were so low by historical comparison that many thought yields could only increase - so the advice was to buy short duration (maturity) bonds where the losses from increased yield would be less.

(Remember, bond prices move inversely with interest rates, so if you think interest rates are going up, it is preferable to be short duration rather than longer duration.)

Bond lesson over. Seasoned investors can look back now.

Some background charts

It is no secret that interest rates have been at record and unprecedented lows since the Great Recession of 2008. The diagram below shows very clearly how the effective Federal Funds rate, the main short-term policy tool of the Federal Reserve, has flat lined since the onset of the financial crisis, only starting to rise from its all-time lows about 12 months ago with the first increase in interest rates by the Fed.

The same picture of historical lows is also true of yields - the following graph shows the path of Government bond yields of 3-year, 7-year and 10-year maturity over the last thirty six years.

At the end of 2008 yields fell to lows that had not been seen in most investors' lifetimes. On the final day of 2008, yields on the 3, 7 and 10 year Treasuries stood at 0.76%, 1.87% and 2.25% respectively.

Given few people had ever seen yields that low, the general consensus was that yields could only go up from there, and this fear of yields rising in the future became the main theme driving investors in bonds to stay away from longer duration bonds. Indeed, "go short duration" has been the cry of many investment reports for several years now.

So I was curious as to how much the 'short duration' recommendation has cost (or benefited) the investor that would have taken that advice.

The cost of being short duration

The way I analyzed the returns from being invested in different maturities along the yield curve was to look at the returns from six iShares ETFs which are invested in different maturities along the US Government yield curve.

The six ETFs are:

Name of ETF

Invested in maturities

SHV

0-1 Years

SHY

1-3 Years

IEI

3-7 Years

IEF

7-10 Years

TLH

10-20 Years

TLT

20+ Years

The returns from these different ETFs are shown in the table below for each calendar year from 2009.

% Return

2009

2010

2011

2012

2013

2014

2015

2016

SHV

0.20

0.16

0.07

0.02

0.01

0.00

-0.01

0.43

SHY

0.54

2.22

1.43

0.31

0.23

0.48

0.43

0.75

IEI

-1.86

6.55

8.1

2.09

-1.95

3.14

1.67

1.22

IEF

-6.38

9.29

15.46

4.06

-6.12

8.92

1.55

1.00

TLH

-8.39

9.57

21.58

4.09

-8.48

14.42

1.28

0.91

TLT

-21.53

9.26

33.6

3.25

-13.91

27.35

-1.65

1.36

The shockingly poor returns of 2009 from being invested in long maturity government bonds seemed to provide a vindication to those who had been arguing for short duration. A loss of over 20% from being invested in 20+Years maturity bonds, compared to eking out tiny gains from being invested up to maturities of 3 Years helped to provide investors with the evidence they needed to invest in low-return, short-maturity bonds rather than being exposed to the high risk of long-maturity bonds.

The problem with this investment approach, though, became blatantly obvious (isn't hindsight a wonderful thing) when comparing the returns on the shortest maturity SHV ETF (0-1 Years) with the longest maturity TLT ETF (20+ Years) over the following years.

Indeed it is an approach that went disastrously wrong in the following year (2010) - 0.16% returns from SHV versus 9.26% from TLT, before going calamitously wrong the year after that (2011) - 0.07% versus 33.6% returns.

Even a poor year in 2013 for long duration bonds was more than made up for by outsized returns in 2014.

The last two years have been virtually flat with little difference in returns across the different parts of the yield curve.

A more visual representation of the returns in the table above is show in the following diagram:

The final score

The following table shows the cumulative return from being invested in the different ETFs for the whole period from 2009-2016.

ETF

Cumulative Return (2009-2016) / %

AER / %

SHV (0-1 Years)

0.88

0.11

SHY (1-3 Years)

6.55

0.80

IEI (3-7 Years)

20.10

2.32

IEF (7-10 Years)

28.93

3.23

TLH (10-20 Years)

35.95

3.91

TLT (20+ Years)

29.26

3.26

The results are quite staggering - being invested in maturities under one year for the eight year period from 2009-2016 would not have even returned as much as 1% - cumulatively! Even investing slightly further along the yield curve, which many investors have been, would have returned an eight year return of 6.55%, or less than 1% a year. Contrast that with the returns from being invested in any of the three ETFs holding bonds of maturity 7 years and upwards, which returned at least 29% over the period in question, and the difference between where investors positioned themselves on the yield curve becomes very stark.

For example, the SHV ETF (0-1 years) returned 0.88% against the TLH ETF (10-20 Years) which returned 35.95% - over 40 times the return!

Conclusion

The motivation for writing this article was borne out of the fact that I have heard it suggested many times over the last few years, that investors should be positioned short duration. The reasoning being simply that the risk of yields going higher meant it was not worth picking up the extra few basis points in returns from holding long duration positions.

As the era of low yields turned out to be not as transitory as many had thought, I was interested to see how much extra return the investor would (did?) have made if he or she was actually invested in longer maturity bonds throughout the period dating from the beginning of 2009. I was surprised at the results - the difference in cumulative return over eight years being between 36% returns (10-20 Years) and 7% returns (1-3 Years) is quite simply huge!

Looking forward, the interesting things is that yields now are not very far off at all from where they were at the end of 2008, which is where the analysis in this article is dated from. Whether being long duration once again proves to be the correct thing to do or not will obviously depend on whether yields have broken the multi-decade downtrend or not - something that only the coming months will tell us. But the results of investor decisions as we enter 2017 could be, as this article has shown, extremely significant for future returns.

Disclosure: I/we 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.