Stick With Short-Term Governments

by Alan Lavine and Gail Liberman

For your bond investments, consider sticking with U.S. government bonds that are non-callable and have maturities ranging from one to five years. That’s the upshot of research by two executives of McLean Asset Management Corp., in Virginia.

Alejandro Murguía, Ph.D., director of investment research, and Dean T. Umemoto, CFP, president, say it’s tempting to invest in longer-term bonds. After all, long-term bonds typically pay significantly more interest than shorter-term bonds.

However, there’s good reason for this. When interest rates rise, a bond loses principal if you go to sell it. The longer the bond term, the more you risk losing in a rising-rate environment.

Say interest rates rose 1 percent: A two-year U.S. Treasury bond would lose close to 1.90 percent of principal while a 20-year U.S. Treasury bond would lose about 10.15 percent of principal if you go to sell it. If issuers of long-term bonds didn’t pay so much interest, nobody would buy them.

Is the higher yield really worth the risk?

Meanwhile, a critical reason many investors hold bonds is to cushion their losses if the stock market heads South.Murguia and Umemoto wrote in a recent issue of the Journal of Financial Planning that during market upswings, bonds usually follow the performance of stocks. But because bonds normally don’t do as well as stocks, financial advisers too often try to compensate by investing in riskier, but higher-yielding corporate bonds and longer-term bonds.

However, the researchers note that bonds are important holdings to have because they help cushion stock market losses. When the stock market drops, bonds “decouple” from stocks. This means they don’t fall in value as quickly as stocks, and might even gain a little. The shorter-term bonds, they say, show greater independence from stocks than longer-term bonds.

In market declines, corporate bonds and mortgage securities tend to do worse than U.S. Treasuries, they say.

During the bull market between 1983 and 1993, when interest rates dropped from 16 percent to 6 percent, long-term bonds did indeed out perform shorter-term bonds, the two acknowledge.

But in the five years preceding that period, when rates rose, long-term bonds suffered when compared with short-term bonds.

Bottom line: If you look at performance throughout that entire interest rate cycle, long-term bonds weren’t worth the added risk.

The authors confirmed earlier studies that indicate when investing in bond mutual funds, you’re typically better off sticking with an index fund rather than an actively-managed fund.

This primarily is due to the fact that you’re paying higher fees for active management. The added fees come directly out of your returns.

The authors separated the funds into quartiles based on their performance histories measured against other funds and a corresponding index fund. The top-quartile funds consistently underperformed the corresponding index funds. Much of the shortfall, the authors conclude, is due to higher expenses for the actively managed funds.

Among the high performing actively managed funds, they say, much of the value-added returns seem to stem from additional credit risk and call-option risk.

By taking on added risk, they indicate, an adviser could be undermining the very reason you’re holding bonds—which often is to lower your risk!

The two conclude that rather than having your bonds actively managed, you could be better off either in index funds or simply holding bonds with variable maturities.

Alan Lavine and Gail Liberman are husband-wife personal finance columnists, journalists and authors. They are the authors of "Rags To Retirement," published by Alpha Books. Their columns appear in newspapers throughout New England and the Southeast, as well as online. Their commentary on mutual funds and personal finance is carried by 200 radio stations nationwide every Sunday over Business News Network's Charles DeRose Financial Advisor Show. Al and Gail’s new book is "Rags To Retirement:  Stories from people who retired well on much less than you think," published by Alpha Books.

More articles by Al and Gail can be found here.