Why Shorter-Term Bonds Might Not Be Your Best Bet

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Ever since the Federal Reserve signaled that an end to its quantitative-easing activity might come sooner than later, the bond market has suffered some fairly cataclysmic losses. Interest rates on Treasury bonds and other forms of debt have backed up substantially, causing dramatic price declines for investors who own bonds and bond funds.

The conventional wisdom in a rising interest rate environment is to seek out shorter-duration bonds. Although following that advice limits your potential capital losses from falling bond prices if rates do, in fact, rise, it doesn't always give you the best total return over time.

Understanding the yield curve
Most investors intuitively understand the typical upward-sloping yield curve. It makes sense that if you're willing to lock up your money for a longer period of time, you should earn more interest in exchange. Right now, the slope of the yield curve is reasonably steep, with one-year Treasuries yielding just 0.13%, while 30-year Treasuries will pay you almost 3.8%.

Over the years, it's also become easier to find bond funds that own bonds with specified ranges of maturities. For instance, the iShares Barclays 20+ Year Treasury (NASDAQ: TLT  ) focuses on long-duration Treasury bonds, while at the other end of the yield curve, the iShares Barclays 1-3 Year Treasury (NYSEMKT: SHY  ) has much shorter bonds in its portfolio.

You can find the same range in inflation-indexed Treasuries, with iShares Barclays TIPS Bond (NYSEMKT: TIP  ) focusing on longer-duration TIPS, while the corresponding iShares 0-5 Year TIPS Bond (NYSEMKT: STIP  ) owns only shorter-duration inflation-indexed Treasury bonds.

Considering the alternatives
But there's another way to think about interest rates, and it has to do with the choices you have when you invest. Consider two investors: one who decides to buy a $1,000 10-year Treasury yielding 2.8%, and the other who opts for a shorter duration $1,000 five-year bond yielding 1.75%.

Ten years from now, we know that the 10-year Treasury buyer will have earned a total of $280 in interest over the decade, representing 10 years of interest at that 2.8% rate. The five-year bond holder, on the other hand, will have to buy another five-year bond in 2018 to replace the maturing one that was bought now. With the current five-year bond paying a total of $87.50 in interest, the replacement bond will have to pay $192.50 in order for that investor to break even. That would require the new bond to carry an interest rate of 3.85%.

In some cases, the rate rises implied by the yield curve are even more dramatic. Two-year bonds currently yield less than 0.5%, while three-year bonds yield about 0.9%. An investor who bought a three-year bond now would have to be able to find a two-year bond in 2016 that carried an interest rate of more than 3% -- six times what two-year Treasuries pay currently.

Similar circumstances govern inflation-protected TIPS right now. In fact, with short-duration TIPS carrying negative real returns, it's hard to make progress after inflation without going long.

Taking the sure thing
Of course, it's possible that rates will, in fact, rise quickly enough for bond investors to profit from making repeated investments in short-term securities. Yet, for years, bond-market bears have expected that to be the case, only to have their expectations thwarted by continued low rates.

Before you reflexively move everything into short-duration bonds, consider the loss of yield that you'll suffer immediately as a result. You might well end up on the short end of the stick in the long run.

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