Should I Add Long Term Bonds to My Investing Portfolio and Asset Allocation?

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Previously on My Personal Finance Journey, I have mentioned several times that I prefer to invest in short-term and TIPS (inflation protected) bond funds for the fixed income portion of my investing strategy and asset allocation and tend to steer clear of long-term bond funds.

As I mentioned in Part 3 of Creating and Implementing Your Investment Strategy, the reason why I avoid long term bond funds is because it was recommended to do so in the investment books I used to develop my investing strategy (Stocks for the Long Run, A Random Walk Down Wall Street, and What Wall Street Doesn’t Want You to Know). The case that these books present against long term bonds is that:

• Academic research has shown that short-term fixed income investment instruments have:
  • 1) Less interest rate risk, and 
  • 2) Equal, if not higher returns than long term bonds.
• Because of these two factors, short-term (1-3 maturities) fixed income investments are considered superior to long-term ones.

However, as I was conducting some research recently for a guest post on the topic of dollar cost averaging, I noticed that during the years of 1992-2012, long-term bonds actually OUTPERFORMED the S&P500 index by almost 30%.

This finding got me thinking – does it still make sense for me to exclude long-term bond index funds from my investing strategy?

As such, in today’s post, I wanted to take a look at each of the reasons given above for why short-term bonds might be potentially superior to long-term bonds and see if they are in fact valid. So, let’s get started!

Do Short Term Bonds Have Less Interest Rate Risk Than Long Term Bonds?

As can be seen in the table in red, the long-term bond fund had >2 times the price volatility than the short-term bond fund, a level almost equivalent to the 100% equity S&P500 index fund.

This increased price volatility can be seen very clearly on the graph below, which charts the price change of both funds over the 20 year period. As you can see, while the blue curve (short-term bonds) increases smoothly over time, the red curve (long-term bonds) experiences a much greater degree of price swings.

Conclusion: Short-term bonds do indeed have MUCH less interest-rate risk/price volatility than long-term bonds. 

Do Short Term Bonds Have Higher Returns Than Long Term Bonds?

Next, I analyzed the overall performance (% increase in portfolio value) that each portfolio realized over the 20 year period from 1992-2012. The results are shown in the table below.

As was mentioned previously, long-term bonds realized higher returns than equities during the 20 year period and MUCH HIGHER returns than short-term bonds (almost 2.5 times more in fact!).

Conclusion: Short-term bonds DO NOT have higher returns than long-term bonds. 

Does Inclusion of Long Term Bonds Provide A Diversification Benefit?

An important question to answer regarding whether or not to include any asset class in a portfolio is if that asset class will provide a diversification benefit.

According to Modern Portfolio Theory (MPT), a diversification benefit is realized when any two assets have a correlation coefficient of their returns/price movements that is not equal to 1. This is due to the fact that assets whose prices move different helps preserve capital and provide a favorable shift on the Efficient Frontier.

As such, I ran a correlation coefficient analysis on the 20 year performance data for the 3 portfolios mentioned above. The results are shown in the table below.

As expected, both short-term and long-term bonds are weakly correlated with equity returns (0.75 and 0.79 correlation coefficients). However, short-term and long-term bond prices move together in the same direction 97% of the time (correlation coefficient of 0.97), meaning that they are very strongly correlated with each other. This implies that long-term bonds provide some, but not much, added diversification benefit if you already have short-term bonds in your portfolio.

Conclusion: Inclusion of long-term bonds along with short-term bonds provides minimal, if any, diversification benefit. 

Overall Verdict on Long-Term Bond Funds

How about you all? What type of fixed income securities do you invest in with your retirement/investing funds? Short-term bonds, long-term bonds, TIPs, municipals, or something else altogether?

Share your experiences by commenting below!

You can view the complete numerical analysis used in this post by clicking the following Google Docs spreadsheet link.