A Dull but Important Question

Ever stare at bond yield curve and wonder what maturities to buy? Or even worse, listen to some bozo analyst explaining to Uncle Lou with a grave but sagacious expression that "in the current interest rate environment our viewers  would be well advised to purchase intermediate bonds of high quality."

Well, folks, you can't get there from here. Attempting to evaluate the risk/return characteristics of a single asset isolated from the portfolio it will be harmonizing in concert with is wasted effort. One cannot simply taste the butter to determine its effect on the finished cake.

I'll make this one short and sweet. Bonds are the underwear in your portfolio -- unexciting and not much thought about, but select the wrong pair and you'll be surprised at just how uncomfortable you are.

Let's start with data supplied by Ibbotson and DFA. We've constructed a global stock portfolio for the 1/70-3/97 period consisting of one quarter each large and small foreign and domestic equity. Next, we mixed it with 30 day, 1 year, 5 year, and 20 year treasuries. The return/risk curves for each bond duration is then plotted.

As you can see, unless you are at the very high end of risk tolerance, the long bond is a terrible idea. It's not an investment -- it's a wager on interest rates. Likewise, unless you are at the very low end of risk tolerance t-bills are a bad idea too. One and 5 year treasuries seem to work the best over the vast middle range of stock/bond mixes that make up most of our portfolios.

The above plot seems to show that the optimal maturity for the long haul is somewhere in the 1 to 3 year area. In order to pin this down a bit further, I compared the CEI mixed with either the DFA 1 year fixed income fund and the Vanguard Short Term Fixed Income Fund for the past 5 years. These 2 funds are virtually identical in makeup and expenses, except that the DFA fund has a duration of 1 year, and the Vanguard fund an average duration of 2.2 years (with an average maturity of 2.6 years).

As you can see, it really doesn't make much difference, except at very low risk levels, where the 1 year duration seems to work the best.

The short version? Use bonds/bond funds of less than 5 year average duration or maturity. Expenses are everything, and unless you are already a DFA customer the Vanguard short term funds are tough to beat. One attractive alternative is to construct your own treasury ladder, which will yield about the same as even the DFA and Vanguard short term corporate funds, since the fund expenses are not much less than the currently razor thin spread between treasuries and high grade corporates.

 

copyright (c) 1997, William J. Bernstein