As short rates rise the tendency for novice bond investors is to believe that the short end of the curve suddenly makes it irrational to hold any long-term bonds. While it’s true that the risk/reward of short-term bonds improves in this environment it doesn’t mean that long bonds serve no purpose in diversifying a portfolio.
Here’s a very good video from Cathy Jones, Schwab’s Chief Fixed Income Strategist outlining three reasons why you shouldn’t abandon long-term bonds as short rates rise. In short:
- Long bonds better diversify your portfolio from stocks. Short bonds are safe because they have less interest rate risk. So their principal fluctuations will be smaller. This cuts both ways though. Interest rates usually fall when stocks decline substantially because it means that there’s a real economic event occurring. In 2008 we saw widespread deflation so rates collapsed. Since long bonds are more sensitive to interest rates they were the instrument that jumped 25%+. They were one of the only true diversifiers in a portfolio in 2008 while short bonds performed more like cash and offered little to no uncorrelated protection from the stock crash.
- Short-term investments are not a replacement for bonds. Long bonds will almost always generate more income over time. So, for anyone with a moderately long time horizon who can ride out the principal fluctuations of high quality bonds it makes little sense to guarantee lower average annual income in exchange for greater short-term certainty just because you are too impatient to wait out principal fluctuations.
- It’s really hard to time the market. People who only hold short-term bonds are trying to time the bond market. They are essentially saying that the long end of the market is wrong and that it’s irrational to hold those longer-term bonds. This thinking has been wrong for 40 years yet people still believe it.
These are good lessons to remember. I like to think of the stock market as a 25 year high quality bond that will pay us about 7% per year if we wait it out. But you have to be willing to wait several decades to see that come to fruition with any certainty. Diversifying our portfolios across the bond market is how we reduce our average waiting time (and uncertainty) without reducing it to nothing (cash) and earning nothing. So, just as it never makes sense to own an all-or-nothing position in stocks it also makes no sense to own an all-or-nothing position in the bond market.
NB – I have a whole section on understandings bonds if you are a turbonerd who enjoyed this article.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.