How to Avoid Hidden Costs in Your Bond Allocations

By Bob Veres

April 1, 2014

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The supposedly safe move to shorten bond maturities in anticipation of rate increases has been very costly over the last three years – and there’s no reason to expect the next three will be any different.  Here’s how to quantify those costs and position your portfolios in a way that makes money in a variety of interest-rate scenarios.

There’s a broad consensus that interest rates are about to head upwards as the economy recovers and the Fed’s bond market intervention comes to a messy conclusion.  Depending on how rapid the rise, this could have a problematic or catastrophic impact on bond prices and your clients’ fixed-income allocations.  Therefore, the very best thing you can do for your clients is confine their bond allocations to ultra-short maturities or floating-rate bonds, or set them up in a conservative bond ladder.

Congratulations! You’ve just made a wise sector bet.  And you did it with near certainty that the outcome, despite all the usual caveats about predicting the future, will be favorable for your clients’ net worth.

Right?

This, of course, was the conventional wisdom around this time three years ago, and the reason it sounds so familiar is that it has been the conventional wisdom ever since.  With the recent announcement by Fed Chairperson Janet Yellen that the taper is on schedule, short-term rates may increase and the Fed’s future policy guidelines are more nebulous, you are hearing these same dire warnings even as we see a mild jump in Treasury yields.

But if you look back over the past three years, it becomes clear that your wise sector bet actually lost your clients money.  As the reader can see in Chart 1, prepared by Performance Trust Capital Partners in Chicago, interest rates actually went down over the last 36 months (ending March 11) across the entire spectrum of the Treasury yield curve.  The interest rate drop ranged from just under 3 basis points for 3-month bills to 84 basis points on the 30-year bond.

Bond Allocations

“If you look at the graph of day-to-day rates, there was a lot going on.  Rates were going up, and down and Europe was going to collapse,” says Brian Battle, Performance Trust’s director of analytics.  “But at the end of the day, if you took a longer-term perspective, nothing happened in the bond market.  You would have been far better off buying 5-year Treasury bonds and collecting 2% a year than hunkering down in 3-month bills at 7 basis points.”

Are you kicking yourself?  Probably not.  “Opportunity costs are invisible unless you take the time to measure them,” says Battle.

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