SOMEBODY OUT THERE is buying and holding longer-term bonds—but you probably shouldn’t. Yes, they’ll notch big gains if interest rates fall, but perhaps suffer even bigger losses if the upward trend in rates continues.
To be sure, investors in almost all bonds have been hit this year, with the iShares Core U.S. Aggregate Bond ETF (symbol: AGG) down 9.6% in 2022 through May 13. Shorter-term funds have fared better but are also in the red, with Vanguard Short-Term Bond ETF (BSV) off 4.1%.
Still, I’d argue that the bond market’s best combination of risk and return can be found among such shorter-term bond funds. To understand why, look at the two yield curves in the accompanying chart, which I created using Treasury Department data. The two curves show the yields available on Treasury bonds of various maturities.
The lower, orange line is the yield curve as of a year ago. Back then, with the Federal Reserve suppressing short-term rates in an effort to stimulate the economy, the yield curve was “steep” in Wall Street parlance, meaning you could get a whole lot more yield by venturing into longer-term Treasurys.
Next, check out today’s yield curve, which is the blue line. Across the board, interest rates have climbed, pushing down the price of existing bonds. But here’s the deal: Beyond about three years, the yield available on Treasury bonds flattens out. Yields in the three-year vicinity are 2.79%, while at 10 years they’re just 2.93%. There is a 3.32% yield at the 20-year mark. But to earn that yield, one that’s just 0.53 percentage point higher than three-year Treasurys, you have to take an awful lot of interest-rate risk. After all, the iShares 20+ Year Treasury Bond ETF (TLT) is down 21.3% in 2022.
Looking at today’s yield curve, I contend it’s easy to see the sweet spot—it’s right there in that three-year area. You’re getting a yield comparable to much longer-term bonds, but these three-year bonds will suffer far less if interest rates continue to climb.
By contrast, long-term bonds have a poor risk-reward ratio. The chance of severe price declines is high, and you aren’t being paid nearly enough to take that risk. Yes, the flip side is that longer-term bonds will appreciate more than shorter-term bonds if rates fall from current levels. But shorter-term funds strike me as the better-odds play. Think of it as swinging for singles and doubles instead of homers.
Go to a fund company’s website or to Morningstar.com, and you can find a fund’s “effective duration”—a measure of interest rate sensitivity based on the maturities of the bonds held by the fund. Your best bet is a fund or combination of funds with a duration of two to three years, meaning they’d only fall 2% or 3% if interest rates rise by another full percentage point. By contrast, intermediate funds and total bond market index funds generally have a duration in the five- to seven-year range, so you’re looking at 5% to 7% losses if rates rose another percentage point.
Armed with this yield curve information, you might trade in your longer-duration funds for shorter-duration funds with less interest rate risk but comparable yields—unless, of course, selling your current fund would trigger a big taxable gain.
What if you have a loss in a fund—like I did in an intermediate Treasury fund—and you’re reluctant to sell? You might want to get over it. Moreover, if the fund is in a taxable account, you could use the loss to reduce your 2022 tax bill. At this juncture, to hope for a rebound in bond prices is basically to bet on a recession or that today’s high inflation will be temporary. That smacks of speculation—or perhaps stubbornness because you hate selling at a loss.
I’m not suggesting that amateurs like you and me can guarantee the best performance by analyzing interest rate data or that we should be actively trading our bond portfolios. None of us will be the next “bond king.” But I think we should understand the interest-rate risk we’re taking—and aim for the best risk-reward tradeoff.
William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.