In a previous post I wrote on investing and economic risk, I recommended a well-diversified, low-cost index fund portfolio as the best stock and bond investment. For the fixed income portion of that portfolio (which, yes, should be a permanent fixture in your long-term portfolio) I have long recommended the use of shorter-term bonds. This is true across a variety of economic conditions, and becomes especially important when inflationary concerns loom large.
Let’s explore why...
In the lingo of investing, there are two primary ways to invest: stocks and bonds. A stock is a small ownership stake in a company. A bond is a loan. The bond is less risky because if the business goes bankrupt, bonds have to be paid in full before the stockholders get anything. In addition, bonds generally offer a steady stream of income.
As a general rule, it is wise to allocate a significant percentage of your portfolio to bonds to temper the risk you’re taking with your stocks. Including bonds in your portfolio reduces overall portfolio volatility.
But why shorter-term bonds in particular? After all, long-term bonds offer higher interest rates. If you’re planning to hold onto them for a long time, why not get the bond that pays the most? Because there’s a catch to stretching for that seemingly “free” extra interest.
Consider this image (click on it to view enlarged version):
At first glance, they’re just a couple of lines intersecting. What do they mean?
The blue, bottom line shows increasing risk. Bond values drop when interest rates go up. The longer the term, the greater the drop (and the greater the risk). The gold, top line is the interest rate. Since 1964 (based on data available), one-month government bonds have averaged a 5.45% return. Five-year bonds have averaged a 7.27% return. This makes sense – five-year bonds have more risk, so they offer a higher return. By extending the bond term from one month to five years, the investor increases risk but gets an additional 1.82% return.
So far so good. But now look where the lines intersect, at about the five-year point. Past a five-year term, the blue line shows that risk continues to increase dramatically. But the gold line shows that the interest rate increases only by a paltry 0.10%!
You have to wonder, why take on the extra risk, when you can expect very little additional return?
Answer: There’s really no good reason to take on extra risk unless there is a commensurate expected return. And that’s why I generally recommend short-term bonds instead of long-term bonds. I will add one final note. There are times when you’d be glad to have long-term bonds – mainly when interest rates are falling, because long-term bonds increase in value when interest rates fall. But with interest rates relatively low these days, and with inflation likely (in my opinion) to push interest rates higher over the next few years, now seems to be a very good time to follow this rule of thumb: Reduce volatility in your stock portfolio with short-term bonds, not long-term bonds.