Retirement Risk: Coming Up Short with Short-Term Bonds

You'd think that sticking with short-term bonds is the smart, conservative move to make right now given the likelihood that interest rates are bound to rise. In fact, you're probably thinking you deserve some bonus points for not being greedy and stretching for yield, given the ominous warnings that we are closing in on a fully inflated bond bubble.

But it turns out that even the most well-intentioned risk-averse approach can backfire a bit. While short-term bonds should always be a part of your fixed-income portfolio, there is in fact a long-term tradeoff if you go overboard and stick solely to the short end of the bond pool.

I hit on this risk in an earlier post http://moneywatch.bnet.com/retirement-planning/blog/retirement-beat/gorging-on-bonds-prepare-for-upset-portfolio/471/?tag=content;col1 , but some additional Vanguard research helps illuminate the risks of being too short-sighted.

Led by chief economist Joseph Davis, Vanguard ginned up some hypothetical future returns across five different economic scenarios. The first scenario below is what the conventional wisdom expects will play out from here. But as the Vanguard team acknowledged in their recent paper, the conventional wisdom is often quite wrong, so it took a look at a few other scenarios as well. Scenario #5 is the "yikes our deficit is so bad, rates (and inflation) are going to have to spike" hypothetical. The takeaway across all scenarios is that what you gain in terms of short-term protection by staying short on the yield curve, you could more than give back in terms of potential long-term gains.

Source: Vanguard

Vanguard being Vanguard, the advice here isn't to try and time your way in and out of the short and long ends of the yield curve. Rather, the argument circles back to sticking with a well-diversified portfolio that holds a variety of durations. Boring? You bet. Sound Advice? You bet. Here's a nice graphic that makes a compelling case for not trying to get too cute with timing the bond market:

Source: Vanguard

Vanguard's takeaway:

A key lesson of the global financial crisis is that implementing a too narrow or "surgical" bond allocation (such as by shortening duration or investing solely in riskier bond instruments) involves important trade-offs that may expose investors to unintended yield-curve or credit risks, while potentially depriving them of a higher or less volatile future income stream. The high uncertainty surrounding the future direction of economic growth, the deficit, inflation, and interest rates would seem to support greater fixed income diversification, not less.

Related MoneyWatch articles:
The Conventional (Bond) Wisdom is Always Wrong
How to Prepare for Inflation

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