Long Term Bonds Vs Short Term Bonds

2011 February 21
by Kyle Bumpus
from → Investing And Investments

The investment world, it seems, is full of conflicting information. While the core advice on the importance of asset allocation and diversification rarely differ much amongst credible experts, the details can be almost polar opposites of one another. One expert will recommend investing mostly in total market index funds (Bogle) while other equally-reputable experts recommend a slice n’ dice approach (Ferri, Bernstein) al0ng with every position in between (Swensen, et al). And that’s just for stocks!

The question of whether to invest in short term bonds, long term bonds, emerging market bonds, corporate bonds, etc has become the subject of some debate of late, as if we needed to make this any more complicated. As with the stock advice above, most of the differences in opinion on which type of bonds to invest most heavily in is more style over substance. Just about any of the plans will work if you stick with it for the long term. Still, the path you choose could influence the ride quite a bit. Today, we’ll focus on the debate between short-term and long-term bonds.

Long Term Bonds

Strengths

  • Higher On The Yield Curve - Following in the time-honored tradition of “more risk, more return,” long term bonds tend to sport significantly higher yields than their shorter-term brethren (excepting during periods of an inverted yield curve) to compensate for their higher risk of default and higher volatility.
  • Protects Against Deflation - Inflation gets a lot more attention, but deflation can be far more damaging. The distant maturity dates of long term bonds will keep the interest payments flowing while prices fall, increasing the real purchasing power of your investment income. As an added bonus, you’ll make a mint with long-term bonds as interest rates fall in response to deflationary pressures.
  • More Stable Income Stream - Long term bonds take longer to mature and so you (or your bond fund) will need to roll over the principal into newer bonds less often (bonds that may bear a lower coupon). Simple.

Weaknesses

  • Very Sensitive To Interest Rates – Long term bonds have high durations, which means their prices tend to fluctuate wildly in response to relatively mild changes in interest rates. Most long term bond funds seem to hover around an effective duration of 10 years or so, which means the fund’s NAV will rise or fall about 10% for every 1% change in interest rates.
  • Vulnerable To Inflation - When inflation picks up, interest rates go up as well. And guess what that does to bond prices? Yep, it pummels them.

When/Why You Should Own Them

In my opinion, you should only hold long-term bonds if you are

  1. a retiree who needs a high and stable interest income, or
  2. feel interest rates have peaked

I must admit that the deflation-protection point is very compelling. Some, such as Harry Browne with his Permanent Portfolio (not to be confused with PRPFX) specifically include long-term bonds for their deflation-protection properties. Most experts will grant that point; however, they will also argue (correctly in my opinion) that that short-term bonds, especially short-term government bonds, offer superior risk-adjusted performance.

Short Term Bonds

Strengths

  • Inflation Resistant - Since short-term bonds have such short maturities, the market is pretty good at pricing in short-term changes in inflation. Barring a sudden hyper-inflationary environment, just how much can prices levels surprise you, anyway?
  • Interest Rate Insensitive - As you might guess, short maturity implies short duration, which means your principal won’t fluctuate much with interest rates. Add to that the fact that interest rates tend to be a bit more stable over periods of less than a year or so and you’ve got a relatively stable asset class.

Weaknesses

  • Low Yields – Short term bonds are very safe and thus don’t pay very well. But that’s okay.
  • Volatile Yields - If interest rates drop, your income stream is going to drop soon thereafter. The upside is that your bond allocation will track rising interest rates just as quickly, of course.
  • Vulnerable To Deflation - The opposite of long term bonds. You won’t get an extra real yield boost with short-term bonds since they turn over so quickly.

When/Why You Should Own Them

I believe the best answer to this question is “unless you have a specific reason not to.” Short term bonds tend to have a superior risk/return profile relative to long term bonds and are usually better diversifiers, to boot, since short term bonds tend to have much lower default risk than their long term counterparts. In short, if you’re having trouble deciding which type of bond to own, you’ll almost never go wrong choosing short-term bonds over long-term bonds.

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One Response
  1. 2011 February 25

    It is worth noting that it doesn’t have to be all of one or the other. The fact is we really don’t know where interest rates are headed. So, for example, if 30% of your investable assets are allocated to fixed income, you could invest 15% in AGG and 15% in CSJ. AGG is an ETF that is indexed to the overall U.S. bond market. It includes governments, agencies, mortgage-backeds and corporates. It has the duration of the overall market. Then you could put the remaining 15% in CSJ which has a much lower duration and is comprised of corporate bonds which have a higher yield. In this way you have a bit of a hedge against rising rates.

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