Are You Going Too Short Term In Your Bond Portfolio?

by: Charles Schwab

By Kathy Jones

KATHY JONES: With the Federal Reserve raising interest rates over the past couple of years, short-term investments like treasury bills and CDs with maturities of under a year or so have become very popular with investors, and rightly so. In the treasury bill market, a one-year T-bill right now will generally yield around 2.3%. A year ago, you would have had to buy a seven-year treasury note to get that much yield. So, naturally, investors have gravitated to the part of the market where they can get more yield with less interest-rate risk over time. But one of the concerns that we have is that investors may be getting too short term in their bond portfolios. I'm Kathy Jones, and this is Bond Market Today.

1As the Federal Reserve has been raising short-term interest rates over the past couple of years, we've suggested investors focus the average duration in their fixed income portfolios in the short-to-intermediate-term area - that is, two to five years for treasuries and investment-grade corporate bonds. And the reason is that as the Fed raises short-term rates, the yield curve tends to flatten, the difference between long- and short-term rates tends to narrow, and you get more return for less interest rate risk at the shorter end of the yield curve. But we don't think investors should abandon intermediate- or longer-term bonds entirely in their portfolios, and there are three reasons for this.

The first is for diversification from stocks. So, typically, what has happened in the past is when the stock market goes down substantially, bonds will tend to rally - high-quality bonds, that is - like treasuries. And while short-term investments like T-bills will hold their value, generally speaking, treasury bonds have historically actually rallied. And that helps keep the overall value of the portfolio more stable than it otherwise would be. We went back, actually, and looked at bear markets and stocks all the way back to the 1930s, and we compared the performance of treasury bills with one-year maturity and treasury notes, intermediate-term treasury notes, during those downturns in the stock market. And most of the time - the vast majority of the time, actually - bonds have outperformed the treasury bills. There were a couple of exceptions. In the 1970s, when inflation was very high, the bonds tended to underperform the T-bills. But, in general, the bonds have provided that diversification when the stock market goes down. And that's important for investors because if there's a point in time when the market is down, you don't want to be selling your stocks when they're going into a decline. You want something that's appreciated in value.

The second reason is that cash and very short-term investments are not a replacement for bonds in a financial plan. So, usually, we suggest investors concentrate their fixed income portfolios over a broad spectrum of time over their investing time horizon. And very few people have an investing time horizon of under one year. And that way you've balanced out your portfolio between stocks and bonds over the long term, and you've invested for cash flow over time.

The third reason is that it's really hard to time the market. And by holding all of your fixed income investments in very short-term maturities you're implicitly trying to time the market, and you may miss out on earning more income and compounding that income over time if you don't time the market just perfectly.

1This video was taped on 9/17/2018. Current suggested average duration for Treasuries and other taxable bonds is the two- to seven-year range.