Other Voices

Making the case against short-term bonds

By John B. Fox

Jan 10, 2010 @ 12:01 am (Updated 2:04 am) EST

In November 2008, many investors believed we were on the edge of financial disaster. Panic was sweeping Wall Street and Main Street. The global economy was in disarray. Now, a little more than a year later, stock market values have rebounded sharply, frozen credit markets are now flowing more freely, and there is greater liquidity in the financial -system.

Some central banks around the world have already begun to raise interest rates in response to early signs of a global recovery, fueling speculation about how and when the Federal Reserve will pursue a so-called exit strategy from its unprecedented intervention in support of the U.S. economy.

Even though our economy still faces strong head winds, many investors fear the side effects of record government borrowing, a falling U.S. dollar and rising commodities prices. As a result, many have decided to rush into short-term bonds or cash to hedge against the “inevitability” of rising rates. But is this an appropriate response? Moreover, what are the risks to bond investors from this seemingly conservative move?

The first risk is evident to anyone who has shortened the duration of their bond portfolio in this environment: rock-bottom yields. With short-term interest rates as low as they possibly can go and with the Fed's pledge to keep these rates low “for an extended period of time,” the negative difference in yield between short- and longer-term bonds is a costly one. And every day that rates do not rise is a day in which those cumulative differences in forgone yield pile up. The futures market is currently telling us that investors don't expect the first tightening until at least the end of this year.

Another risk to consider is that rather than 1970s-style inflation, the U.S. economy instead is facing a long-term deflationary environment much like Japan has experienced over the last two decades. Back in 1997, when the yield on 10-year Japanese government bonds first went below 2%, most investors thought those yields would quickly shoot higher. Twelve years later, they are still waiting. With the prospects of sluggish long-term economic growth and a jobless recovery for the U.S. economy very real, the downward pressure on asset values and long-term rates (and hence the upside of owning longer-term bonds) is considerable.

This outcome could ravage investor portfolios, especially for those who rely on interest income to meet everyday expenses. Investors who keep the duration of their bond portfolios too short run the risk of choking off their income stream over time as short-term bonds are continuously reinvested at low yields.

Most experts agree that a Japan scenario, in which rates come down and stay down for an extended period of time, is unlikely in the U.S. because of differences between the two markets. However, that scenario should serve as a cautionary tale for anyone convinced that they know what the future holds, especially when it comes to the inevitability of rising interest rates.

Finally, even if we assume that the economy does start to recover and the Fed begins to tighten sometime this year, would short-term bonds still make sense then? Not necessarily. To see why, consider what happened to municipal bond returns during the last rate-tightening cycle.

On Dec. 31, 2003, the federal funds rate was at 1%, and the Federal Open Market Committee had just changed its policy outlook from “balanced with risk of deflation” to just plain “balanced” — a not-so-subtle indication that a tightening cycle was coming. And tighten the Fed did. Starting in mid-2004, it hiked rates 17 separate times in increments of 25 basis points, eventually raising interest rates to 5.25%.

During that period, short-term rates rose dramatically, while longer-term rates either rose less dramatically or actually fell, because the Fed exhibited enough credibility to convince the long end of the market that it was serious about fighting inflation.

What was the net result for municipal bond investors between 2004 and 2006? Investors holding bonds with longer-term maturities fared better than investors holding short-term bonds. In some cases, long-term bonds outperformed short-term bonds by hundreds of basis points as was the case with the 7.65% cumulative return for the Merrill Lynch 5-Year Municipal Bond Index, compared with the 15.56% cumulative return for the Merrill Lynch 15-Year Municipal Bond Index.

Ultimately, the biggest mistake individuals make with their bond portfolios is investing with too short of an investment horizon. This is because most investors worry too much about principal fluctuations (as an equity investor would) and not enough about the bigger risk in bonds — that of reinvestment risk. The risk that interest rates will remain low or go lower for a long period of time, especially for those at or near retirement, should not be ignored.

Advisers should engage their clients in a frank discussion about reinvestment risk. Intermediate and longer-term bonds could be a better long-term solution for certain bond investors because locking in the higher yields associated with a steep yield curve can better guard portfolios against the menace of rock-bottom yields.

The structure of a bond — the fact that it always matures at par — only reinforces this approach, because it limits the downside risk to principal associated with any rate rise, while allowing investors to focus on maximizing long-term income — the most important component of a bond's long-run return.

For shellshocked investors wary of the markets, “inevitability” remains a dangerous concept.

John B. Fox, a chartered financial analyst, is senior vice president and co-director of fixed income for Gannett Welsh & Kotler LLC.

  @IN Wire

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