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By Christine Benz and Eric Jacobson | 12-05-2013 12:00 PM

Bond Duration: Should Everyone Be Short?

Shortening your bond portfolio may protect you in the near term if rates rise, but there is an opportunity and diversification cost that investors should be aware of, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Ever since interest rates jumped up this past summer, investors have been rushing to shorten up their portfolios' durations. Joining me to discuss this topic is Eric Jacobson. He is a Senior Fund Analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: It's great to be with you, Christine. Thanks.

Benz: It's good to see you in-person for a change.

Jacobson: Thank you.

Benz: Eric, we have been watching this phenomenon. Let's talk about whether you see investors flocking to short-term bonds when you look at where fund flows have been going?

Jacobson: Absolutely, there is no question. Investors have been running to different areas, including more credit-sensitive bank-loan funds, but also the short-term bond category, as you mentioned. For the year to date, the flows have been over $30 billion, which is pretty significant, given that the size of the category at this point is only just under $300 billion. It's been a pretty sharp move, and you can't discount the fact that a lot of managers themselves have been shortening up their own portfolios. So, even if you don't own a short-term bond fund you're probably feeling that as well.

Benz: Eric, how should people be thinking about this? I think a lot of investors' tendencies have been really logical. People, obviously, don't want to get caught off-guard by another big rate shock. But how should they be thinking about the durations of their bond portfolio. Should everybody be short?

Jacobson: That's a really important question because the fact is that if everybody is moving in the same direction, is that really a great idea to follow the herd? We see it a lot in other parts of the market. We don't often think about it in terms of bond funds, but really we are seeing that pretty broadly. The real question is, Is this really going to happen, and is it going to be a big enough issue to really justify this kind of move because, well, you may be protecting yourself from a near-term interest-rate spike. The question is: A) is that going to happen; and B) what does it mean to your portfolio? Because the fact is that you are giving up the opportunity perhaps to make more money, certainly, with higher-income investments than a short-term bond portfolio, but even more importantly perhaps is you are giving up some insurance from that portfolio because you don't have the interest-rate sensitivity that otherwise helps diversify a portfolio.

Benz: You are saying in a market shock in which, say, stocks go down--your cash or your short-term bonds, they won't go down, but they won't go up either?

Jacobson: That's right. And they won't provide the kind of ballast that perhaps you'd hope that they would. The only asset that performed well during 2008 and perhaps saved a lot of investors' portfolios from having huge drawdowns is that Treasury bonds rallied. And if you look at the way that a lot of managers try to hedge their different kinds of risks in their portfolios, they think of duration as a hedge for that reason--because they want that Treasury as an insurance policy.

Benz: Another thing that I think comes to mind is if everyone is going to short-term bonds, does that at some point get to be a crowded trade and do short-term bonds, in fact, get a little bit expensive, maybe relative to their very low yields right now?

Jacobson: Yes. I think that there is a general sense that it is very crowded trade. We've talked to a few managers that have expressed that sort of thinking. It means perhaps different things in the short-term universe. I think the biggest issue is that you can't expect to make a lot of money. You can't expect bonds like that to keep up in a broader rally. You're not picking up very much extra income over anything else because as you say they're very tight and perhaps overbought.

The good news is that because they're so short, over a reasonable period of time you shouldn't get too badly hurt. The basic premise is that they're not sensitive to interest rates--not very sensitive to interest rates. So, short-term bonds, constantly approaching maturity--they tend not to move as much or be as volatile. So, you certainly have that, but you are giving up a lot, potentially.

Benz: OK. So, let's think about this in terms of a real-world portfolio. If I have money that I'm going to need in the next couple of years, it seems reasonable to maybe keep that shorter-term. How about if I have money where I have a slightly longer time horizon, maybe, say, a five- to seven-year time horizon. What should I be doing with that?

Jacobson: I think there's a huge temptation now for people to get out of there and get into other kinds of funds. But I go back to the basic thinking about how to build a portfolio, and why do you have bonds: Are they ballast toward your stocks? What do you expect for them? Are they going to be an insurance policy? I think it's really a big question as to whether or not you should take … I think a lot of people are taking all their money out of core bonds and even intermediate duration funds. You don't necessarily see that among all institutional investors. There has certainly been money pulled out of  PIMCO Total Return PTTRX, for example, but they are not changing that portfolio's basic mandate because they have a lot of clients that still feel that they need to have some duration in the portfolio.

The other options are certainly attractive to people right now--short duration as you're talking about or unconstrained portfolios--but you really want to be careful about what other kinds of risks you're taking on because many funds, in order to compete, do other things, other than take on duration risk, when you switch away from that.

Benz: You mentioned credit risk. A lot of these funds do, in fact--the floating-rate, certainly, and some of the other categories that have been seeing good inflows--do take on more credit risk?

Jacobson: Absolutely. The bank-loan funds have really been real strong aggregators of assets. I don't think anybody is worried about a big credit blowup anytime in the very near future, but the fact is that's a universe that's getting very tight in terms of pricing. At some point, it's going to be priced for perfection. At some point, we're going to have some sort of dip in the cycle. People that thought it was a safe place to go, I hope won't be too shocked. Hopefully, people know what they're getting into, but it's certainly a concern.

Benz: OK. Eric, tricky time for bond investors. Great to have you here to talk about it.

Jacobson: Thanks a lot, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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