Duration giveth, and duration taketh away.
For much of the past 35 years, while interest rates were in a secular decline, duration (a measure of a bond’s sensitivity to changes in interest rates) was the best friend of bond investors. In 2018, it has become their worst enemy.
At one end of the spectrum, you have short-term Treasury bills (BIL) with a duration of 0.1 and a total return of 0.6% year-to-date. At the other end of the spectrum, you have long-term zero-coupon bonds (ZROZ) with a duration of 27.3 and a total return of -10.0%.
The correlation between duration and year-to-date returns in the table of popular bond ETFs below? -0.86.
Data Source: YCharts
While 10-Year Treasury yields have risen from 2.4% to 3.06% in 2018, the largest bond ETF (AGG) is down 2.81% and the largest bond mutual fund (VBTLX) is down 2.84%. The duration on both instruments is roughly 6 years.
If this trend continues through the end of 2018, it would be the worst year ever for U.S. bonds.
Needless to say, bond investors aren’t accustomed to such declines – bonds tend to be synonymous with safety. This mismatch between expectations and outcomes can lead to adverse behavioral responses (aka selling at the wrong time).
Which brings me to the title of this post: do bond investors have to take duration risk? Said another way: do bond investors have to be willing to accept short-term principal losses when interest rates rise?
In an aggregate bond fund like AGG, the answer is clearly yes, but what if we look outside the bond market to the sleepy world of certificates of deposit (CDs). Here we find something quite interesting, particularly for longer-term bond investors who do not need daily liquidity.
The highest yields on various CDs (from 1 year to 7 years) today are comparable (and oftentimes higher) to U.S. Treasuries with similar maturities.
Data Source: Bankrate.com and Stockcharts.com
And a 5-year CD (3.06%) has a higher yield than the AGG ETF (3.03%).
Like a savings account (click here for recent post on how to maximize your yield on cash), CDs come with FDIC insurance of up to $250,000 (per account/depositor/account type). And unlike a bond fund, an investor in a CD will not see principal fluctuations. The principal balance only goes up with each interest payment until maturity.
What’s the catch? Why doesn’t everyone just buy CDs instead of bonds?
If you don’t hold a CD to maturity, you will have to pay a penalty to get your money back, often 3 months’ worth of interest but can be higher depending on the bank/maturity.
With a no transaction fee bond mutual fund, you can sell at the end of each day with no penalty and with a bond ETF you can sell intra-day less only the cost of commission (which can be free if it is a commission-free ETF at your broker).
A CD requires effort in finding the bank with the best interest rate, opening up a new account, and making sure you do not surpass the FDIC limit (if you want to eliminate credit risk of the bank). When a CD comes due, many have the option to automatically renew at the same term at whatever the latest rate is, but if you want to shop for a higher rate, you will have to repeat this process all over again.
By comparison, the effort in purchasing bond ETFs/funds is minimal and requires virtually no maintenance.
If you live in a high tax state, buying Treasury bond ETFs or funds with similar interest rates may be preferable as they are exempt from state income tax.
CD interest is fully taxable at the federal and state level.
4) Interest Rate Risk
If interest rates rise, you may be locked into a lower yielding CD. While there are “bump-up” CDs that give you the option of moving interest rates up (typically once) during a term, they often come with lower starting yields.
During a period of rising rates, bond funds are constantly reinvesting principal and interest into higher yielding securities, but at the same time they incur price declines on their existing bond holdings.
One way to mitigate liquidity and interest rate risk in CDs is to create what’s known as a “ladder,” where you break your total investment up into various maturities (ex: 1-year, 2-year, 3-year, 4-year, 5-year) and when the shortest maturity comes due (1-year in this case) you reinvest at the longest duration (5 years in this case). This will give you access to a portion of your funds every year and if interest rates rise you can reinvest that portion at a higher rate. The trade-off: at least initially you will be accepting a lower portfolio yield than if you simply put everything into the longest maturity option. And if interest rates fall, you will be reinvesting at a lower rate.
Who is the Winner?
Whether a CD is better for an investor than an aggregate bond fund will depend on a multitude of factors, many of which cannot be predicted in advance (most importantly, the direction of interest rates). What we can say with confidence is that for investors with little tolerance for drawdowns in the low-risk bond portion of their portfolio, CDs may be worthy of consideration. While the value of the certificate of deposit may go down when interest rates rise, the fact that investors cannot see that decline can be an important psychological benefit. If you can stick with CDs because they always appear to be going up but cannot stick with bond funds because the short-term losses are transparent, that may be reason enough to go with CDs. This is true regardless of which vehicle ends up with a higher return.
The investment strategy you can stick with is often the best strategy.
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