Short-term Bonds vs. Long-term Bonds

Maybe it’s the appeal of the simple alliterative headline, but “Bond Bubble” has been getting plenty of play across personal finance pages, cautioning investors who flocked to the relative safety of fixed income during the financial crisis and Great Recession that risk looms on the horizon if interest rates increase, causing bond prices to fall.

Yes, rising inflation and higher interest rates can diminish bonds’ value, if the time to maturity is long term in nature (typically five years or greater.) Accordingly, over the past 18 months, in an environment where higher rates and inflation could be in our future, we have significantly trimmed back on longer maturities and added shorter term bonds to your asset mix.

These bond decisions are governed by the fact that bonds’ function in the portfolio is to reduce volatility while creating a consistent income stream commensurate to the steepest point on the bond curve. In addition, bonds have a very low standard deviation (riskiness) and lower correlation to equities, making them a superior choice to enhance portfolio diversification.

Short-term bonds can provide an effective hedge against inflation, as well as an essential portfolio stabilizer, whether interest rates inch up over the next few quarters or increase by several points years into the future.

Recently, I came across a powerful article by Fidelity’s Dirk Hofschire, Remember the Attributes of Bonds. Hofschire underscores bonds’ stabilizing value by looking at the extreme inflationary period from 1970 to 1980 when inflation averaged nearly 8 percent before peaking above 14 percent in 1980. He found that when inflation averaged above 9 percent, from 1974 to 1980, stocks returned 10 percent while high-quality bonds returned only about 6 percent, making for negative real returns when measured against more than 9 percent inflation.

However, importantly, especially for investors who would write off bonds as appropriate investments in inflationary times, Hofschire also found that the volatility of bond performance during the 1970s when inflation raged out of control was considerably lower than that of stocks. In fact, the volatility (also referred to as the standard deviation or riskiness) was about 6 percent on an annualized basis from 1970 to 1980, far below the 16 percent standard deviation of stock returns.

Our lesson is clear. Although stocks achieved better returns than bonds during the 1970s, high-quality bonds did their job of lowering portfolio volatility, even under the most extreme inflationary pressures.

Interestingly, even when Hofschire expanded his timeframe to encompass the multi-decade period from 1941 to 1981, he found that a 20 percent allocation to high quality bonds reduced a portfolio’s overall volatility by 20 percent, yet only marginally lowered the overall return, from 11 percent to just below 10 percent. Additionally, he found splitting the bond/stock allocation 50/50 cut the portfolio’s volatility in half, while average returns declined by about a third, from 11 percent to 7 percent.

What is the bottom line? As Hofschire concludes, the steadying influence of bonds when inflation ran rampant in the 1970s provides us with some “historical comfort.” Further, diversifying between stocks and bonds to stabilize portfolios remains at the core of smart portfolio construction and will enable long-term investors to weather all types of markets.

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