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Shifting Bond Maturities and My Latest Mistake

When interest rates rise, bond prices fall. Because today’s interest rates are extremely low, some investors worry that interest rates could rise sharply in the future, thereby causing bond prices to fall sharply.

One method of protecting yourself from such an event is to shift your bond allocation from longer-term bonds to shorter-term bonds.

The reason this would offer you some protection is that when market interest rates rise, a bond’s price (or bond fund’s price) will fall by an amount approximately equal to its duration, multiplied by the increase in interest rates. For example, if a bond fund has an average duration of 3 years, and interest rates rise by 1%, the fund’s price will fall by approximately 3%.

Therefore, if you shift from one bond fund to a shorter-term bond fund of similar credit quality, the amount of protection you’d gain is approximately equal to the difference in the funds’ respective durations, multiplied by the increase in interest rates that eventually occurs.

For example, if all interest rates rose by 2% tomorrow:

  • Vanguard Total Bond Market Index Fund (average duration = 5.2 years) would fall by approximately 10.4% (5.2 x 2%), while
  • Vanguard Short-Term Bond Index Fund (average duration = 2.6 years) would only fall by approximately 5.2% (2.6 x 2%).

On the other hand, because shorter-term bonds have lower yields than longer-term bonds, you’ll be earning less interest in the interim. To continue our example, according to Vanguard’s site, the difference in yield for the two funds above is currently 1.67%. So if rates go nowhere, the cost of shifting to the shorter-term fund would be approximately 1.67% per year in forgone interest.

My Experiment with Shifting Maturities

When I first created my index fund portfolio, it looked like this:

  • 40% Vanguard Total Stock Market Index Fund,
  • 40% Vanguard FTSE All-World Ex-US Index Fund,*
  • 10% Vanguard REIT Index Fund, and
  • 10% Vanguard Intermediate-Term Treasury Fund.

In November 2010 though — while making an IRA contribution and rebalancing our portfolio — I moved from the Intermediate-Term Treasury fund to Vanguard’s Short-Term Treasury Fund in order to pursue the strategy described above. Interest rates were very low, and it seemed clear to me that they’d be increasing at some point.

But with the help of some members of the Bogleheads forum, I eventually realized my plan was poorly conceived:

  • I intended to move back to the Intermediate-Term fund at some point, but I had no specific plan for when to do so. I was just making it up as I went along;
  • I had absolutely no idea how long it would take before interest rates would rise; and
  • As somebody who makes a conscious effort to ignore economic news (hence the name of this blog), it’s likely that I wouldn’t even notice when interest rates eventually did reach a more historically-normal level.

After mulling it over for a couple months, I finally moved back to the Intermediate-Term Treasury Fund. This time I plan to stay put.

Why am I telling you this?

Admittedly, in my particular case, this mistake was rather trivial. It was only 10% of my portfolio, and it was a shift from one type of bond to a mostly-similar, lower-risk type of bond.

Still, it was a poorly reasoned decision, and hopefully we can draw a lesson from it.

That lesson: It’s easy to make observations about current market conditions (e.g., “by historical standards, interest rates are unusually high/low” or “by historical standards, stocks are expensive/cheap”). But interest rates can stay low (or high) and stocks can stay cheap (or expensive) for a very long time. And unless we can predict when things will change, it’s difficult to draw much benefit from such observations.

*This has since been replaced with Vanguard Total International Stock Index Fund. At the time I created my portfolio, the Total International fund had a higher expense ratio, but that’s no longer the case.

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Comments

  1. It might be semantics but I don’t look at it as a poorly reasoned decision. There were very good reasons to expect rates to rise. As it turned out the economy didn’t recover as it typically had, the Fed sopped up an unprecedented amount of Treasuries in its two quantitative easing programs and Europe failed to deal with its on going debt problems.
    When you market time (and that’s what you did) you obviously always stand the chance of this happening.
    The important consideration is what you are doing now. Extending duration with the 10 year Treasury at 2% I don’t think is a good move especially with the Fed on the brink of “operation twist” whereby they will buy longer dated Treasuries.

  2. DIY Investor,

    As it turns out, my timing (moving to ST in Nov 2010 and moving back in April 2011) actually worked out pretty well:

    But my point is, that was purely luck. I don’t actually pay enough attention to economic news — or know enough about it to make truly educated guesses even when I do pay attention — to be able to succeed with such things on a regular basis.

  3. I also don’t think it was a mistake. You took lower risk and as it turned out, you didn’t even get a lower return. Respected advisor Larry Swedroe said he stayed in short-term nominal bonds instead of long-term TIPS. You can ask him how much he “lost” because of that.

    http://www.bogleheads.org/forum/viewtopic.php?p=1171652#1171652

  4. TFB, I’m not arguing that it turned out poorly. It didn’t. (And even if it had, as I mentioned above, the impact would be negligible given the small portion of my portfolio.)

    What I’m arguing was/is a mistake is thinking that just because interest rates are lower than average, it’s necessarily a good idea to move to shorter-term bonds.

  5. I greatly respect your opinions on investing (recently signed up for your newsletter), and I appreciate you taking the time to explain why you moved to short term treasuries and why you have ultimately decided to move back to intermediate and stay the course. Thanks for explaining why you feel you made a “poorly reasoned decision” even if it wasn’t a mistake in terms of performance. As a relative newcomer to index investing, this post is a great reminder to me to stop over thinking things and stick with the plan. Thanks.

  6. Hi rallycap.

    I’m happy to hear you found the post helpful.

  7. Seems to me the danger is in doing things on a whim as opposed to following a well-reasoned plan. If your plan was to shift to shorter maturities and you were merely following the plan, no mistake made.

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