How I Learned to Love the Bond, (at least short term bonds)

Bonds have become a hot topic of discussion of late, as current issues are affecting bond performance.  Bonds are unalterably a part of your portfolio. Avoiding bonds means you lose their great ability to diversify, lower risk and provide liquidity. Presently, we are only recommending short-term bond funds. Let me explain why.

Take a look below at how different bond maturities are doing. The table below shows the total return for different maturities, which is the combination of price change and interest rate yield.

In a normal interest rate environment, the longer the bond maturity is, the higher the total return.  See the 5 year or 3 year return. Yet, notice the negative numbers in the longer term bonds listed in the 1 year return.   This is directly due to the rise in interest rates in the last year. The Fed drove interest rates down to historic lows and now rates have nowhere to go but up.  Consequently, bond prices will continue to fall until we reach a normal bond environment. 

More interesting, the best returns in the last year came from bonds in the 1-3 year maturity. This is where your bond holdings are focused now. It is a temporary solution that will be rectified once bonds return to a more normal interest rate environment.

How much did interest rates move in 2013?  The U.S. Treasury offered the following rates for government bonds at the end of 2012 and 2013.

Interest rates jumped at least 1% for all bonds that had maturities of 5 years or longer. In this abnormal bond environment, the best place to be is in short-term bonds. The interest rate risk is simply too high in longer maturities.

This makes sense when you think about it. Throughout the year, investors flocked to short-term bonds to protect themselves from interest rates. The high demand for short-term bonds allowed the bond’s yield to be kept at low rates. On the other hand, longer-term bond issuers had to increase yield to entice investors, further lowering the bond’s price.

These are unusual circumstances, unlikely to happen twice in a lifetime because of the movement of interest rates are left to markets to determine. But this is a manmade intervention, and those seem to be coming more often. Stay tuned.