June 5, 2013

Why Your Bond Allocation Matters

On May 2nd, 2013, the yield on the 10 year Treasury bond closed at 1.63%.  By June 4th, the yield had risen to 2.14%, a 31% increase in rates over a little more than a month.  Basic bond math shows that as yields rise, bond prices fall.  Managing this ‘interest rate’ risk is one of the central roles of portfolio management.  One of the ways of managing this risk is to allocate the bond portion of the portfolio to various types of bonds and maturities.  The chart below shows the performance of the following investment grade bond ETFs:

  • iShares Floating Rate Note ETF – FLOT
  • Vanguard Short-Term Corporate Bond Index ETF – VCSH
  • Vanguard Intermediate-Term Corporate Bond Index ETF – VCIT
  • Vanguard Short-Term Inflation-Protected Securities Index ETF – VTIP
  • iShares Barclays TIPS Bond ETF – TIP

Source: Yahoo Finance and Fifth Set Investment Advisors LLC

One can easily see from the chart that bond allocation matters a great deal.  The best performing ETF was FLOT, up 0.1%, which holds investment grade floating-rate notes.  Unlike fixed rate bonds, floating rate note coupons adjust periodically based on a short-term benchmark rate so as rates rise generally, the yield on a floating-rate note should also rise, thereby mitigating interest rate risk.  At the other end of the spectrum was TIP, down 4.4%, which holds long-term Treasury Inflation Protected Securities (TIPS).  A TIPS bond’s principal increases based on realized inflation which makes them beneficial inflation hedges.  However, the TIPS coupon is typically lower than a traditional bond.  As a result, TIPS bonds are more susceptible to rising rates when there is no corresponding increase in inflation expectations.  When yields rise, all else being equal…

  • Shorter maturity bonds are less risky than longer maturity
  • Floating rate bonds are less risky than fixed rate bonds
  • Higher coupon bonds are less risky than lower coupon bonds
  • In the absence of a corresponding increase in inflation expectations, inflation-protected bonds are riskier than traditional bonds.