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Are Bond Funds Unusually Risky Right Now?

If there’s one thing that’s clear from reader emails, it’s that many people are concerned — or even scared — about the riskiness of their bond holdings right now. The questions I keep getting over and over are whether intermediate-term bond funds (e.g., Vanguard’s Total Bond Market Index Fund or Fidelity’s Spartan U.S. Bond Index Fund) are unusually risky right now and whether moving to shorter-term bonds would make a portfolio less risky.

The answer to those questions depends on what you mean by risk.

Risk = Likelihood of Low Returns?

For people who think of risk as the probability of earning negative inflation-adjusted returns, yes, an intermediate-term total bond market fund is unusually risky right now, given how low interest rates are. But from that perspective, a short-term bond fund is even riskier given its lower yield and lower expected return.

Risk = Volatility?

On the other hand, if it’s price volatility (due to changes in interest rates) that makes a bond fund risky to you, then yes an intermediate-term fund is riskier than a short-term fund. But it’s important to understand that from that perspective, a longer-term fund is always riskier than a shorter-term fund. It’s got nothing to do with low interest rates.

In addition, from a price volatility standpoint, I’m not convinced that an intermediate-term bond fund is any riskier than it normally is.

“Autocorrelation” refers to a variable’s correlation to itself from one period to another. For example, a series of data points in which upward movements tend to be followed by more upward movements and in which downward movements tend to be followed by more downward movements is said to have high autocorrelation.

According to the data I’ve seen, interest rates (for both short-term bonds and long-term bonds) have strong positive autocorrelation over short-term periods. For example, according to Yale economist Rober Shiller’s data (and my Excel calculations), from 1871-2011, 1-year interest rates have an 83.6% autocorrelation from year to year. There’s even a 55.5% autocorrelation when you look at the 1-year rate in a given year as opposed to the rate 5 years later. And the autocorrelation for rates on 10-year Treasury bonds is even higher.

In other words, the fact that bond yields have been moving downward over the last few years and now sit well below historical averages does tell us that we should expect low returns from bonds going forward, but it does not tell us that we should assume rates will necessarily rise in the near future. If anything, it would suggest that an extended period of low rates is likely.

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