In December of last year, the Federal Reserve announced “tapering” of the $85 billion monthly bond purchases that had been providing support to the market and the economy. The pace of tapering, which began with a reduction to $75 billion in January and $65 billion in February, continues to be watched closely by many investors because it has the potential to lead to interest rate changes. Last year, the mere discussion of tapering led to bond sales and rising interest rates that caused the prices of many bonds to fall.
The timing of rate changes is uncertain, but in today’s market, short-duration debt investments may have a role in a diversified fixed income portfolio. While investors focused on optimizing total return over multi-year time horizons may still be well-served with longer duration bonds, short duration bonds can help investors looking to limit the potential volatility of total returns as the market reacts to Federal Reserve policy adjustments. Short duration bonds may also be an option for those who are trying to generate more income than money market funds or savings accounts.
Short duration defined
“Short duration” typically refers to debt investments with maturities from a few months to five years—the range between money market funds and intermediate bond funds. In a rising rate environment, these investments generally experience price declines that are less pronounced than those of longer-duration investments of equivalent credit quality. For example, if interest rates were to rise by 1%, a bond or bond fund with an average duration of 10 years might drop approximately 10%, while a similar investment with a one-year duration might decline only 1%.
Decoding bond terms
- Interest rate risk: The risk of price declines due to higher interest rates.
- Duration: A measure of price sensitivity to changes in interest rates, with a longer duration generally indicating more sensitivity than a short duration.
- Short duration: Debt investments maturing within five years.
- Yield curve: A chart that plots the yields of similar bonds across different maturities.
- Credit rating: An indication of the creditworthiness of a bond issuer or a particular bond.
While short duration bonds may experience smaller price swings, these investments tend to produce less income than longer-duration fixed income instruments, and smaller total returns over multi-year time periods (see table below). So, for investors with a multi-year investment horizon whose primary need is current income or long-term total return, there may be better options. (Read Bond strategies for today’s markets.) Also, short duration bonds and bond funds should not be considered substitutes for savings accounts or money market funds. They can produce more income than those investments, but they have more risk of price volatility, so they shouldn’t be used for savings that may be needed immediately.
In 2013 short duration strategies outperformed
Last year provided an example of how short duration bonds may perform in a rising rate environment. In May of 2013, the mere suggestion of the Fed’s reduction in its monthly bond purchases, which have been constructive for low rates, caused the market to react immediately: Investors sold bonds, pushing the yield on the 10-year Treasury to its highest level in two years. That rise in rates led to performance losses for many bonds and bond mutual funds during the year.
As the table below shows, Treasury bonds with longer durations have delivered attractive returns over multi-year time horizons. But during 2013, longer duration bonds underperformed bonds with shorter durations, because of their higher interest rate sensitivity, and because shorter duration interest rates rose less than longer duration rates.
|When rates rose in 2013, short-duration outperformed longer-duration Treasury bonds.|
|Index Name||Duration||Annualized returns as of 12/31/2013|
|Barclay's 1-3 Year Treasury Index||1.8||0.36||0.78||1.11||2.57|
|Barclay's 1-5 Year Treasury Index||2.5||-0.14||1.36||1.60||3.10|
|Barclay's 1-10 Year Treasury Index||3.6||-1.34||2.26||2.11||3.73|
|Barclay's 5-10 Year Treasury Index||6.5||-4.68||3.80||2.97||4.99|
|Barclay's 10-30 Year Treasury Index||16.0||-12.66||5.53||2.28||5.94|
|Source: FMRCo, 12/31/2013.|
In addition, while long-term returns have been attractive for corporate investment-grade and non-investment-grade (high yield) bonds, as well as for municipal bonds, in 2013 shorter duration bonds also performed well.1
Why short duration now
There are some reasons to believe that the coming months or years have the potential again to deliver attractive returns to bond investors opting for shorter durations.
Global economic improvement and contained levels of inflation have heightened the potential for the Fed to reduce its level of accommodation in monetary policy. As long as inflationary expectations remain in check, the Fed has pledged to anchor the shortest-term rates at historically low levels until well past the time that the unemployment rate declines below 6.5%. Given the current pace of economic growth, these conditions may continue in the future. At the same time, rates on longer-duration bonds have moved higher in anticipation of both the Fed’s further tapering its bond purchases, and continued improvement in the economy. In 2013, this led to a steeper yield curve—yields for three-, five-, and seven-year Treasury bonds more than doubled versus year-end 2012. In contrast, yields for two-year Treasuries rose by only 0.13% (from 0.25% to 0.38%), and Treasury yields shorter than one year actually fell (from 0.02% to 0.01%).
A steep yield curve can make short duration investments appealing because they offer potentially attractive yields while limiting interest rate risk. Investors with surplus cash holdings who are willing to take on the potential for more risk and volatility may be able to earn additional income by moving into short-duration bond strategies. At the same time, investors with holdings in longer-maturity bonds may earn attractive risk-adjusted returns by shortening duration in order to reduce interest rate risk.
Choosing the right short-duration options
In general, short-duration fixed income strategies might offer less interest rate risk than longer duration bonds—as well as more income—and risk—than money market funds. That said, within the range of short-duration options, there are a number of choices with respect to risk tolerance and tax efficiency. The best way to pursue a short-duration strategy depends on your investment goals and personal circumstances—in particular, when you will need to access the money you are investing, and how much performance volatility you can tolerate.
Among Morningstar’s categories, funds investing primarily in higher credit quality ultrashort bonds may offer low interest rate sensitivity. However, their yields may be lower than those of other short-duration choices. Low yields may lead them over the long term to underperform inflation. Higher credit quality short-term bonds and funds may provide more income than ultrashort investments, in exchange for more interest rate risk. For tax-sensitive investors, short-term municipal options offer tax-exempt income. Investors prepared for the greater volatility and risk of loss that is associated with lower credit quality investments also have options to shorten the duration of their allocation to high yield bonds.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
Treasury bond fund interest dividends are generally exempt from state income tax but are generally subject to federal income tax and alternative minimum taxes and may be subject to state alternative minimum taxes.
High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds.
The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation and your evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.
Past performance is no guarantee of future results.
Diversification/asset allocation does not ensure a profit or guarantee against loss.
Indexes are unmanaged. It is not possible to invest directly in an index.