At John Hancock Investment Management, our portfolio consulting team reviews thousands of advisor portfolios every year, and one trend we’ve been witnessing lately is unusually high allocations to short duration products.
For the past three years, investors have been moving money into short and ultra-short duration bond funds at a rapid clip—nearly $200 billion since the start of 2016.1 It’s been a trend with understandable reasons behind it: The U.S. Federal Reserve (Fed) has been gradually hiking short-term interest rates since December 2015 as it’s worked to normalize monetary policy while yields on the long end of the curve have been near generational lows. From that perspective, investors have been given little reason to take on the extra duration risk. But does the historical performance data suggest that such a move actually pays off? And is it beneficial at the portfolio level for the typical investor?
Looking at the last two Fed tightening cycles—2004 to 2006 and 2015 to 2018—short duration bonds, as measured by one- to five-year U.S. Treasuries, actually underperformed long duration bonds (10+ year U.S. Treasuries). In fact, longer duration Treasuries posted over double the returns in both time periods.
A key point to remember is that a tightening monetary policy doesn't necessarily correspond to rising long-term rates. While the Fed controls the short end of the curve, market participants control the long end based on their expectations for future inflation. And expectations for future inflation remain muted based on a combination of cyclical and secular factors, ranging from fears of an upcoming recession to a growing realization that changing demographics and technology is more likely deflationary.
What about periods when the Fed was easing monetary policy? Looking at the last two examples—from 2001 to 2003 and again from 2007 to 2008—short duration bonds posted gains, but nowhere near the magnitude of those generated by their long duration counterparts. This too makes intuitive sense, but in this case, the data supports the intuition: The Fed is typically cutting rates against the backdrop of an economic slowdown—or, more recently, in the face of a material decline in asset prices—which is exactly when investors tend to flock to the relative safety of Treasuries.
Short duration bonds have tended to offer only short-term protection from rising yields
The one environment in which short duration has reliably outperformed is when long-term yields spike. Going back to 2000, we identified seven distinct periods when yields on 10-year U.S. Treasuries rose by 100 basis points or more—and short duration Treasuries outperformed in every one.
But that trend of outperformance hasn’t lasted. During the 12 months that followed those 100 basis point jumps in yield, long duration bonds posted better returns in all instances—and often by a wide margin.
What does that reversion suggest? For that rare investor who can confidently predict the peaks and troughs in Treasury yields, manipulating a portfolio’s duration profile may offer a measure of temporary downside protection. For the rest of us, this pattern suggests that there’s wisdom in taking a longer-term view. The protection offered by short duration bonds—as the data above suggests—tends to be short-lived, and owning longer duration bonds across cycles has been a strategy that’s tended to work out just fine.
The bigger question: what role do investors expect bonds to play in a portfolio?
One of the primary reasons for owning bonds in the first place is to add ballast to a diversified, growth-oriented portfolio. Historically, Treasuries (both long and short duration) have had low or negative correlations to equities, especially during times of equity volatility. But correlation only measures the direction of performance, not magnitude—and by that token, long duration bonds have tended to be a better diversifier because of their potential to offset equity market declines. This quality often manifests itself in the form of a higher volatility figure, but that volatility tends to appear exactly when it’s needed most.
An example details the impact of short or long duration Treasuries in a simple, two-asset portfolio: one a traditional balanced mix consisting of 60% stocks and 40% bonds, the other a more conservative mix of 40% stocks and 60% bonds.
Despite the fact that long duration U.S. Treasuries entailed more volatility than short duration (10% versus roughly 2%), the volatility at the portfolio level was essentially a wash in the 60/40 mix and only moderately higher when allocating to long duration bonds in the 40/60 portfolio. That would appear to be a reasonable trade-off in both portfolios given the significant increase in both overall return and in the portfolios’ Sharpe ratio; both long duration portfolios also provided materially lower downside capture ratios. For investors who own stocks, duration, it would seem, serves a vital role in a diversified portfolio.
Intermediate-term bond funds can represent an attractive compromise
There is, of course, a middle ground. The largest fixed-income category in the fund industry is intermediate-term bonds, and for good reason. These types of funds entail a moderate level of duration risk, and most active managers have the flexibility—and the incentive—to make changes to their portfolio’s rate sensitivity as market conditions change.
The bottom line is that investors who aren’t in the business of timing the bond market may want to reconsider how useful a short duration strategy is likely to be to their long-term goals. Duration, of course, is a portfolio risk, but it’s one for which investors are compensated for taking in the form of higher coupons. Fixed-income investors with longer time horizons may be leaving returns on the table by looking for safety in short duration bond funds.
1 Morningstar, as of 3/31/19.