Why Short-Term Bonds Can Be a Long-Term Disappointment

Too often, investors want to have it all – high yields and low risk. With mounting speculation that the Federal Reserve will raise interest rates, more investors have flocked to short-term bonds and short-term bond funds. Last year, seven new short-term bond funds were offered, according to Morningstar Inc.

Short-term bonds have higher yields than money market funds, but their short duration – three years or less – provide protection against rising interest rates.

When interest rates rise, bond prices fall, especially longer-term issues. Investors who want to avoid that risk may find short-term bonds – those with maturities of less than three years – appealing. Short-term bonds tend to be lower risk than many other investments, but the reduction in risk may not be worth the sacrifice in yields.

The problem is that too many investors fail to consider the short-term nature of the payout, and they wind up “overthinking” concerns about interest rates. A better way to view bond yields is in the aggregate payment over the life of the bond.

Consider a municipal bond that matures in 2016 with a coupon of 0.80. In two years, it yields 1.6%. Now, under the conventional wisdom, if interest rates rise, then the investor can roll that money into a higher-yielding issue at maturity.

But consider the long-term alternative. Let’s say there’s a bond that matures in 2021 with a coupon of 2.5. In two years, its total yield is 5%, compared with the 1.6% for the short-term issue. Plus, over the remaining five years, it pays another 12.5% in addition to the 3.4% advantage from the first two years. In other words, the long-term bond is yielding 16% over the life, if it’s held to maturity.

That means that for the short-term bond to be the smart play, interest rates would have to rise to at least 3.2%. While rates are likely to rise eventually, it’s uncertain if they will rise to that level in two years. After all, the Federal Reserve has projected that the fed funds rate, which sets the floor on other interest rates, will be only 1.13% by the end of 2015.

It’s worth noting that while some investors are rushing into short-term bonds to avoid risk, many yield-chasing fixed income investors are abandoning the security of bonds and pursing far riskier investments in search of higher returns. They too could benefit from taking a longer-term perspective. Longer-term bonds may offer them a middle of the road between too much risk and too little yield. Remember also that short term mutual funds have a hard time replicating this “over-the-life” scenario. That’s because funds think perpetually, and three years from now are likely to still have a three year maturity. Individual bonds get closer to maturity every day. This gives comfort that an unforeseen spike in rates would inflict minimal damage, and holding to maturity fixes that anyway. Funds typically don’t mature or guarantee a future value which bonds do. And of course the fund is charging another fee that holding the bond does not incur.

Despite their popularity, investors need to understand the shortcomings of short-term bonds. Their relatively low risk isn’t a substitute for the safety of a money market account, and their insulating effects against rising interest rates may not be enough of a benefit to justify the yield that’s lost.

The short-term play, in other words, may not be the smart play.

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