What Kind of Bonds Should I Hold?

Editor's note: This article is part of our "How and Why to Invest in Bonds" series. Click here to read other articles.

It is useful to remember that a bond's classification as short-, intermediate-, and long-term isn't just an abstraction. As Christine Benz notes, investors could also reasonably match their time horizons for each part of a bond portfolio to the appropriate bond type. Money needed for very short-term expenditures (within the next one to two years) is likely best held in cash, whereas assets needed for purchases within the next several years may be OK in high-quality shorter-term bonds. And if that money isn't needed for four or five years or more, intermediate-term bonds and bond funds may look like a reasonable bet. In this regard, duration can be a helpful tool; if a fund's duration is substantially longer than the intended holding period, there's a mismatch at work.

One common rule of thumb for gauging a bond fund's interest-rate sensitivity is that for every 1-percentage-point increase in Treasury yields, an investor could expect to lose an amount of their investment equal to the fund's duration.

But that isn't the only variable. The yield that an investor earns off the fund is also part of the equation; the investor receives that yield regardless of what happens to bond prices.

Thus, to estimate how much an investor could lose during a 12-month period if Treasury yields increased by 1 percentage point during that same 12 months, subtract a fund's SEC yield from its current duration.

Here's how it works using a current (and widely held) bond fund example: Vanguard Total Bond Market Index VBTLX currently has an SEC yield of 2.8% and an average duration of 6.0 years. That means if yields increased by 1 percentage point over a one-year period, one could expect the fund to lose roughly 3.2% during that same time frame--the 6% expected loss of principal would be partly mitigated by the fund's yield.

Meanwhile, the projected losses for long-term U.S. Treasury bonds amid a period of rising rates look a lot more alarming. Vanguard Long-Term Treasury VUSUX has a 17-year duration and a yield of just 2.6%. That means that shareholders could expect to lose almost 14% of their principal during a one-year period if Treasury rates were to jump by 1 percentage point during that same time frame. Thus, while long-term Treasuries have historically been a good diversifier for equities, their interest-rate-related volatility may make them difficult to own.

For more on how to assess a fund's duration, visit this article by Miriam Sjoblom.

At the same time, duration--and the interest-rate sensitivity stress test discussed--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.

Part 7: Bonds: Where Are We Now?

The following authors contributed to this series:

Tom Lauricella, Editorial Director, Professional Audiences Christine Benz, Director of Personal Finance Sarah Bush, Director, Fixed-Income Strategies Jeff Westergaard, Director, Fixed-Income Data

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