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A way to help manage interest rate risk

Shorter duration bonds may provide limited price volatility and varying levels of income.

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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
1-Year 3-Year 5-Year 10-Year
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.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information.  Read it carefully.
1. Total return for the Barclays 1-5 Year Credit Bond Index was 1.24% from January 1, 2013 through December 31, 2013, while total return for the overall Barclays Credit Bond Index, all durations, was -2.01%. Total return for the non-investment grade Bank of America Merrill Lynch 1-5 Year BB-B U.S. Cash Pay High Yield Index for calendar-year 2013 was 7.44%, while the return for the overall BB-B index, all durations, was 6.31%. Total return for the Barclays 1-5 Year Municipal Bond Index for calendar-year 2013 was 1.15%, while the return for the overall municipal index, all durations, was -2.55%.
The information presented above reflects the opinions of Fidelity Management Company’s fixed income division, as of February 12, 2014. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.

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.

Barclays U.S. 1-3 Year Treasury Bond Index is a market value–weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities between one and three years.
Barclays U.S. 1-5 Year Treasury Bond Index is a market value–weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities between one and five years.
Barclays U.S. 1-10 Year Treasury Bond Index is a market value–weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities between one and ten years.
Barclays U.S. 5-10 Year Treasury Bond Index is a market value–weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities between five and ten years.
Barclays U.S. 10-30 Year Treasury Bond Index is a market value–weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities between ten and thirty years.
Barclays U.S. 1-5 Year Credit Bond Index is a market value–weighted index of investment–grade corporate fixed–rate debt issues with maturities of one to five years.
Barclays U.S. 5-10 Year Credit Bond Index is a market value–weighted index of investment–grade corporate fixed–rate debt issues with maturities of five to ten years.
Barclays U.S. Credit Bond Index is a rules-based market value–weighted index of fixed-rate, investment–grade corporate and non-corporate sectors with at least one year to final maturity. . The corporate sectors are Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations. The non-corporate sectors are Sovereign, Supranational, Foreign Agency, and Foreign Local Government.
Bank of America Merrill Lynch 1–5 year BB-B U.S. Cash Pay High Yield Index is a market capitalization-weighted index of U.S. dollar- denominated, below-investment grade corporate debt currently in a coupon-paying period that is publicly issued in the U.S. domestic market, with maturities between one and five years. Qualifying securities must have an average rating (based on Moody’s, S&P and Fitch) between BB and B, inclusive. The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the U.S. or a Western European nation. The FX-G10 includes all Euro members, the U.S., Japan, the U.K., Canada, Australia, New Zealand, Switzerland, Norway and Sweden. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities and deferred interest bonds that are not yet accruing a coupon are excluded.
Barclays 1-5 Year Municipal Bond Index is a market value–weighted index of investment–grade fixed rate municipal bonds with maturities between one and five years.
Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. To be included in the index, bonds must be fixed-rate, have at least one year to final maturity, and be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. The index has four main sectors: general obligation bonds, revenue bonds, insured bonds (including all insured bonds with a Aaa/AAA rating), and pre-refunded bonds.
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