Seeking Direction in Bonds? Let Your Time Horizon Lead the Way

Let's Get Small was Steve Martin's platinum-selling album of the 1970s, and it appears to be the mantra of many bond investors these days, too.

Concerned about what rising interest rates could mean for their fixed-income portfolios, they're shortening up. Funds in the short-term bond category have gathered nearly $30 billion in new assets during the past year, according to Morningstar's most recent asset-flows data, while ultrashort bond funds have pulled in another $12 billion. Short-term municipal-bond funds have seen about $3 billion in new flows.

Investors have also been buying credit-sensitive bonds, which have shorter durations (that is, less sensitivity to changes in interest rates) than high-quality bond types. Multisector and nontraditional bond funds--with median durations of 4.6 and 1.8 years, respectively--have been seeing strong inflows, and bank-loan funds have emerged as the current "it" category. These investments, whose interest rates adjust along with prevailing interest rates (as reflected by LIBOR), have gathered a staggering $58 billion in new assets during the past year, nearly doubling the size of the category from where it was 12 months ago.

Meanwhile, investors have been shunning intermediate-term bond and intermediate-term government-bond funds to the tune of nearly $60 billion in the third quarter alone. Intermediate- and long-term munis and Treasury Inflation-Protected Securities have also been on the chopping block. (Curiously, long-term bond funds have been seeing inflows, albeit fairly modest.)

Potential for Interest-Rate Shocks Are Real
In a lot of ways, investors' retreat from interest-rate-sensitive securities is perfectly rational. The 10-year Treasury is currently yielding about 2.7%, meaning that rates have some, but not a lot, of room to move down, and plenty of room to move up. Because investors typically view bonds as a part of their portfolios they'd like to keep safe--either to meet near-term income needs or to serve as ballast for their equity holdings--risking losses with rate-sensitive securities looks like a loser's bet.

Investors' retreat from high-quality bonds is also rooted in the fact that such bonds tend to be more responsive to interest-rate changes than lower-quality ones. When rates rise, investors would rather buy a new bond with a higher yield attached to it thansettle for the old bond with the lower yield, sothe old bond gets marked down when yields trend up. Treasury bonds and other very high-quality bonds, because they have zero to limited credit risk, tend to be the most sensitive to yield changes; they're a direct reflection of what's happening with Treasury rates.

And indeed, this past summer's interest-rate shock provided an unhappy glimpse into what could happen to bonds in a prolonged period of rising rates. As the yield on the 10-year Treasury jumped up by 130 basis points, or 1.3 percentage points, from May through early September, rate-sensitive bond types took it on the chin. Long-term Treasuries had the steepest losses when yields rose sharply from May through early July, but long-term munis, GNMAs, and TIPS were also among the casualties. Seeing losses of 5%-10% from some of these categories no doubt hastened investors' retreat from them.

Selling Overdone?
I've been among the people warning of interest-rate risk. And indeed, if you have money that you need to keep safe for near-term needs--either for next year's in-retirement living expenses or a tuition payment--it's only prudent to avoid short-term losses in rate-sensitive securities.

That said, not everyone holding bonds needs the money for near-term expenses, and from that standpoint, the mass exodus from rate-sensitive securities and into short-term bonds strikes me as overdone.

For one thing, it's not as though rising bond yields are a universal negative. True, a spike upward in rates will tend to lead to short-term losses in high-quality bonds of all maturities. Even ultrashort bond funds such as Fidelity Ultra-Short Bond posted a small loss during the summer rate shock, for example.

Over time, however, that higher yield also flows through to the investor, eventually making up for the near-term drop in principal value. A recent research paper from Vanguard shows how a 3-percentage-point interest-rate hike would play out on a year-to-year basis. For a portfolio invested in long-term bonds, the rate increase would lead to a devastating loss that would take eight years to recover from--even though the investor would also happen to partake of the newly available higher yields. But a broadly diversified bond portfolio would recover much more quickly: Due to higher yields in the years following the rate shock, the investor who bought and held the portfolio would've recouped his losses and got back into the black on the investment within three years of the rate shock.

Of course, why court the risk of near-term loss at all? Why not shorten up now, then get back in when bond yields are higher? That sounds only sensible, but the hitch is that hunkering down in cash and short-duration bonds carries an opportunity cost. While yields in longer-term bonds have spiked during the past several months, short-term yields are about where they started the year--close to zero. As Vanguard's head of taxable fixed income Ken Volpert argues in this video, even if short-term rates go up from here, intermediate-term yields may not change because they're already pricing in a significant rate uptick.

Match Time Horizon to Bond Choices
Amid all the uncertainty, it's useful to remember that bonds' classification as short-, intermediate-, and long-term isn't just an abstraction. You could also reasonably match your time horizon for each part of your bond portfolio to the appropriate bond type. Money needed for very short-term expenditures (within the next one to two years) is best held in cash, whereas assets needed for purchases within the next several years are OK in high-quality shorter-term bonds. And if you don't expect to need some of your bond money for four or five years or more, intermediate-term bonds and bond funds look like a reasonable bet. In this regard, duration can be a helpful tool; if a fund's duration is substantially longer than your holding period, you've got a mismatch on your hands.

At the same time, duration--and the interest-rate sensitivity stress test discussed in this article--will only take you so far. Just because credit-sensitive bond types such as bank loans and junk bonds have limited durations, they're not appropriate for short time horizons. They may have limited interest-rate sensitivity, but they are sensitive to changes in the economy and the credit cycle. Thus, investors buying such bonds should have an intermediate-term or even longer holding period in mind.

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