Ferri: The Risk Of Short-Term Bond Funds

Beware the consequences of rushing to shorten duration.

Did you miss returns from intermediate-term bond funds because you sat in a short-term bond fund waiting for interest rates to rise? A lot of people did. This strategy has backfired as the opportunity cost of not being in intermediate-term bonds has been more costly than whatever damage rising interest rates might have taken away.

Investment articles from 2009 made a solid case for staying short-term, “As markets continue to slide, many advisors are suggesting that investors play it safe. In the world of fixed income, that means staying on the short side of the duration curve to avoid the threat of rising interest rates,” writes an ETF.com contributor.

A 2010 white paper from RidgeWorth Investments states, “Short-term bonds, best defined as fixed-income products that mature within one to three years, can be an attractive solution given today’s historically low yields and potential for rising interest rates.”

In February 2011, Kiplinger published an article titled, “11 Bond Funds That Won’t Get Soaked by Rising Interest Rates.” They highlighted short-term bond funds.

There were dozens more articles heeding the same warning and advice – keep your bonds short to avoid big losses when the bond bubble bursts.

I never bought into this shorter-is-better mentality. My view has been to remain in intermediate-term bonds even if though interest rates were low, assuming you don’t need all the money in the short-term.  This is the case for most retirees and people who are saving for retirement. Staying intermediate-term has worked best most of the time, and the past three-five year period is no exception.

Table 1 compares the annualized return of two Vanguard index funds over a three- and five-year period ending June 30, 2014. The Vanguard Total Bond Market Index Admiral Shares (ticker:VBTLX) has an SEC yield of 2.13 percent, an average 5.6 year duration, over 6,500 investment-grade bond portfolio, and sports a low 0.08% expense ratio. The Vanguard Short-Term Bond Index Fund Admiral Shares (ticker: VBIRX) has an SEC yield of 0.87 percent, an average 2.7 year duration, nearly 2,000 investment-grade bonds in the portfolio, and has a low 0.10% expense ratio.

Table 1: Comparison of Annualized Returns through June 30, 2014

*before taxes
Source: Vanguard

The growth of $10,000 in each of these funds in the five-year period ending June 30, 2014 is illustrated in Figure 1. An investor in would have earned $1,284.14 more in the intermediate-term VBTLX over short-term VBIRX. This was an extra 11.3 percent in total return.

Figure 1: The hypothetical growth of $10,000 over 5 years ending June 30, 2014**

Source: Vanguard VBTLX  Total Bond Market Index; VBIRX  Short-Term Bond Index

The extra return earned in the intermediate-term Total Bond Market Index fund really adds up over time. VBTLX investors would still be ahead of VBRIX investors even if interest rates jumped by 3 percent this year.

The growth of $10,000 in each of these funds over a three year period ending June 30, 2014 is illustrated in Figure 2. An investor in would have earned $657 more in the intermediate-term VBTLX over the short-term VBIRX during the period. This was an extra 6.3 percent in total return.

Figure 2: The hypothetical growth of $10,000 over 3 years ending June 30, 2014**

Source: Vanguard VBTLX  Total Bond Market Index; VBIRX  Short-Term Bond Index

Investors who made the switch to short-term bond funds between 2009 and 2011 missed out on higher interest over the following years. This “opportunity cost” from being out of intermediate-term bonds cost short-term bond fund investors 6.3 percent in total over the past three years and 11.3 percent in total over the past five years ending in June 2013. Even if interest rates started rising, investors who stayed put in intermediate-term would still come out ahead.

The moral of the story is not to let the fear of rising rates stop you from investing properly. By all means buy a short-term bond fund if you have short-term liabilities. If your liabilities are long-term, stay in an intermediate-term bond fund for the duration. It pays to do so.

**Figures include reinvestment of dividends and capital gains but don’t reflect the effect of any sales charges or redemption fees, which would lower them. The initial investment used in the graph may be higher or lower than the initial minimum amount required to invest in each fund. The performance of an index is not an exact representation of any particular investment as you cannot invest directly in an index. The performance data shown represents past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited.