Ferri: The Risk Of Short-Term Bond Funds

July 07, 2014

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



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