In the search for income, investors sometimes don't pay enough attention to risk. That is a problem with both stocks and bonds. The interesting thing is that risk can often be very rewarding on the equity side of the equation, but with bonds, the reward is often less material than you'd expect. Here's a look at a collection of Vanguard bond ETFs, from the Vanguard Short Term Treasury ETF (VGSH +0.00%) all the way to the Vanguard Extended Duration Treasury ETF (EDV +0.63%).
What is a bond's duration?
A bond is, effectively, a loan made between the buyer of the bond to the seller of the bond. In exchange for cash, the seller of the bond agrees to pay the loan back in full and pay interest while the bond is outstanding. Most bonds require a lump-sum payment at maturity; in contrast, mortgages amortize, with regular payments covering both principal and interest over the loan's life.
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A bond's biggest risk is default risk; whether the issuer can pay interest and return the principal. By focusing on U.S. Treasury securities, that risk is minimized, and some would argue it is eliminated. The U.S. government is considered one of the safest borrowers on the planet. The next biggest risk comes from duration.
A bond's duration is simply the length of the loan. So a loan that will be repaid in one year has a one-year duration. A loan that will be repaid in 30 years has a 30-year duration. There's a big difference between short-duration bonds and long-duration bonds because the bond buyer's capital is tied up for the length of the bond.
If a bond has an interest rate of 5% and market interest rates fall to 4% the value of the bond rises so the interest rate a secondary buyer will collect is 4%. That's good, but the math works the other way, too. If a bond's interest rate is 5% and rates rise to 6% the value of the bond falls so that the yield a secondary buyer would collect is 6%. To put that a different way, the bond has to be discounted in order to attract new buyers. This is what ETF investors have to consider when they look at bond ETFs of varying durations.
VGSH Dividend Yield data by YCharts.
Most investors will be better off at the short end
In the chart above you can see that, most of the time, the highest yield comes from owning the Vanguard Extended Duration Treasury ETF, which has an average duration that will generally fall between 20 to 30 years. The next highest yield is typically from the Vanguard Long-Term Treasury ETF (VGLT +0.28%), which has a duration range of 10 to 25 years. Typically the Vanguard Intermediate Term Treasury ETF (VGIT +0.05%) is next in line, with a duration range of five to 10 years. And pulling up the rear most often is the Vanguard Short Term Treasury, which targets a duration range of just one to three years.
The Vanguard Short Term Treasury ETF and Vanguard Intermediate Term Treasury ETF sometimes switch places when interest rates change. That's because the bonds in Vanguard Short Term Treasury ETF roll over more quickly than the bonds in Vanguard Intermediate Term Treasury ETF, so the interest paid for the short-term option adjusts higher more quickly to rate changes.
VGSH Dividend Yield data by YCharts.
When interest rates were near zero, the rates on the longer-term options were materially more attractive than the shorter-term ETF options. Even still, the difference only amounted to a couple of percentage points. Right now, as the chart above shows, the difference is less than a percentage point between the lowest yield and the highest yield. And the shortest-duration ETF is nearly as rewarding on the income front as the longest-duration ETF. It is very clear that today most investors should probably just buy the Vanguard Short Term Treasury ETF because it has the best risk/reward characteristics.
That brings up the price factor related to duration, which the chart above highlights. In order to keep the interest rate in line with the market when rates are rising, the value of bonds has to fall, as noted above. Long-term bonds tend to take the brunt of the impact. Indeed, while the yield on the longer-term bond ETFs has remained higher than the yields on the shorter-term ETFs, the price decline in the face of rising interest rates has been brutal. So even when the Vanguard Short Term Treasury ETF's yield was super low, it still posed less risk to investors.
VGSH Total Return Price data by YCharts.
The chart above tracks total return, which includes the reinvestment of dividends. The longer-duration ETFs have performed better over time; however, there has clearly been much greater price risk associated with owning them. Holders of the Vanguard Short Term Treasury ETF and Vanguard Intermediate Term Treasury ETF have experienced relatively muted volatility and still fairly decent returns.
Why do you own bonds?
When you include bonds in a portfolio, there are likely two reasons: income and diversification. The diversification side is about risk reduction, which is the balancing act that investors need to think about. Basically, how much income you want versus how much price risk you can handle in your portfolio. It's important to remember that bonds' reduced price risk often serves to balance the substantially higher volatility of stocks.
For most investors, erring on the side of caution and sticking with an ETF like the Vanguard Short Term Treasury ETF will be the best balance of yield and risk. Very few investors should go beyond the Vanguard Intermediate Term Treasury. The yield benefit of going out too long probably won't justify the price risk you have to take on.
