Picking Bonds Based on Performance and Yield

Two readers recently wrote in with similar questions about selecting the type(s) of bonds to use for the bond portion of your portfolio.

Long-Term vs. Short-Term Bonds

Reader #1 asks:

“As of today, Vanguard’s Treasury bond funds have the following performance figures:

• Vanguard Long Term Treasury: 1-year return = 31.6%, 10-year average annual return = 9.08%
• Vanguard Intermediate Term Treasury:  1-year return = 8.7%, 10-year average annual return = 6.2%
• Vanguard Short Term Treasury: 1-year return = 1.45%, 10-year average annual return = 3.54%.

Based on that information, why isn’t everyone buying long term Treasury funds?”

Bond prices and market interest rates are inversely related. When one goes up, the other goes down. And that makes perfect sense if you consider an example.

Arthur buys a 10-year Treasury bond paying 2% interest. Five years later (when his Treasury bond is now effectively a 5-year bond), market interest rates have risen, and new 5-year Treasury bonds are yielding 3%. The result: Because of the rise in rates, nobody would be willing to buy Arthur’s 2% bond unless he offers to sell it at a discount. (That is, interest rates have gone up, so the price of his bond has gone down.)

And the longer a bond’s duration, the more severely its price will change as a result of market interest rate changes. Specifically, the size of the price change will be approximately equal to the change in interest rates, multiplied by the bond’s duration. So, for example, a bond with a 5-year duration would lose approximately 5% of its price if the applicable market interest rate increased by 1%.

In other words, the reason that long-term bond funds currently have higher past performance records than shorter-term bond funds is simply that:

1. They have a longer duration, and
2. Interest rates have been falling fairly steadily over the last few years (thereby pushing bond prices up, with the prices of longer-term bonds going up the most).

As far as the question of “why doesn’t everybody buy the long-term fund,” the answer is simply that the opposite phenomenon can happen as well. That is, in a rising-rate environment, bond prices fall, and it would be the longer-term bonds whose prices would fall most severely.

Nominal Treasuries or TIPS?

Reader #2 writes in asking:

“Currently all TIPS with a maturity of less than 20 years have a negative yield. And even with 20-year TIPS the yield is just 0.09%. In contrast, 20-year normal Treasuries currently yield 2.28%. Even a 3 month normal Treasury (yield = 0.10%) beats a 20-year TIPS. I don’t understand why experts still talk about TIPS as a useful tool when normal Treasury bonds look so much better.”

What makes TIPS unique is that their principal adjusts upward with inflation, and their interest payments are based on the inflation-adjusted principal. In contrast, both the principal and interest payments on nominal Treasury bonds are fixed. As a result, comparing the yield on TIPS to the yield on nominal bonds does not tell you which one will actually earn a greater return.

For example, when we see that a 20-year TIPS has a yield of 0.09%, we know that (as measured in nominal dollars), its return will be 0.09%, plus any inflation that occurs over the 20 years. So by comparing that to a nominal 20-year Treasury with a 2.28% yield, we can see that if inflation is more than 2.19% per year (that is, 2.28%, minus 0.09%), the TIPS will provide a greater return. (And conversely, if inflation is less than 2.19%, the nominal Treasury bond will provide a greater return.)

So the answer to the question of why anybody would use TIPS is simply that many people are worried about the possibility of inflation that’s greater than the difference between nominal Treasury yields and TIPS yields.