Should Short-Term or Intermediate-Term Bonds Make Up Your Fixed Income Asset Allocation?

Learning about investing is an interesting process.

In 2009-2010, I really started learning about passive investing and asset allocation by reading several books by David Bach, William Bernstein, Burton Malkiel, Jeremy Siegel, and Larry Swedroe (side note – isn’t it interesting that someone can get a BS in Finance/Financial Investments, but get out of undergrad without actually knowing how to invest your own money without teaching yourself?!).

By reading these books, I was able to learn enough to put together my asset allocation, figure out which low-cost index mutual funds to buy to make it all work, and then execute/maintain my investing strategy for the past few years without any trouble.

However, as I continue to study investing, I have recently found myself reading through these same books or websites that I read several years ago, but this time, being able to pick a lot of smaller details that I might not have understood the first time through.

One of these small nuances is the decision about how to invest the bulk of your fixed income asset allocation – should the money be placed in short-term or intermediate-term bonds?

Why Not Consider Long Term Bonds?

As I mentioned in a post several months ago where I examined whether it would be wise to incorporate long term bonds in to my portfolio, the whole purpose of my fixed income allocation is to help stabilize my portfolio from the ups and downs that are caused by my equity holdings.

Unfortunately, long term bonds simply don’t do this the way I want. They have a risk/volatility/standard deviation that is on par with the movement of the S&P500 index. Clearly, this is not what I am looking for.

What do the Books Say? – Intermediate vs. Short-Term Bonds

Before I jump in to a long-winded investigation/discussion of my own, I generally like to share any relevant advice from people that are much more qualified than myself. Listed below is what I could find in the literature about deciding between short and intermediate-term bonds for the fixed income portion of your portfolio:

• Larry Swedroe (probably my favorite investing author I have found to date)
  • In his newer 2010 book, The Only Guide You’ll Ever Need for the Right Financial Plan, Larry discusses how at a 60/40 asset allocation between equity and fixed income, Intermediate-Term Bonds give investors the highest Sharpe Ratio (or risk-adjusted return). However, as you increase the asset allocation to 80/20 equity/fixed income, Long-Term Bonds give investors the most efficient risk/return ratio. Quite an interesting finding!
  • Intriguingly, in Larry’s very good 2001 book, What Wall-Street Doesn’t Want You to Know, he states fairly globally that holding bonds with a longer maturity than 2-3 years causes a DECREASE in the Sharpe Ratio (decrease in the risk adjusted return). Clearly, this is different than what he stated in his 2010 book, and it is likely due to the fact that bond returns during the 2000’s were so good compared to stock returns. This same sort of recommendation for 2-3 year maturity bonds is given in the 2005 edition of his book, The Only Guide to a Winning Investment Strategy You’ll Ever Need.
• Burton Malkiel
  • In his famous and amazing book, A Random Walk Down Wall Street, Malkiel isn’t very specific about the short-term vs. intermediate-term bond decision. However, in one location, he does recommend a sample portfolio consisting of the Total Bond Market Fund, which is an intermediate-term (overall) bond fund. 
• William Bernstein (my 2nd favorite investing author I have found to date)
  • In his 2002 book, The Four Pillars of Investing, Bernstein generally sticks to recommending short-term bonds. However, he does mention that you get “the most bang (return) for your buck (risk) at a maturity of 5 years,” meaning intermediate bonds are the most efficient. But, a few sentences later, he recommends keeping the maturity of your bonds between 1-5 years because the stock portion of your portfolio is where you want to take risks, not your bond portion. Since the average maturity of most intermediate-term bond funds are between 5-7 years, it would seem to reason that Bernstein is sticking to recommending short-term bonds.
  • In his 2001 book, The Intelligent Asset Allocator, Bernstein also acknowledges that 5 year Treasury Notes (Intermediate-Bonds) are the most efficient at in returns of return with the least amount of risk. However, he does not actually recommend using Intermediate-Bonds in any of his sample portfolios in the book. Instead, he only recommends short-term bonds.

Clearly, this is a substantial amount of ambiguity based on the recommendations from Bernstein, Swedroe, and Malkiel above.

However, from a conservative perspective, I think I will interpret this mixed-bag of advice as meaning that although intermediate-bonds may be more “efficient” from a mathematical perspective, at a practical applications angle, it is likely better for investors to hold short-term bonds to minimize risks (and leave risk to be taken with the equity portion of the portfolio).

Short-Term vs. Intermediate-Bonds as a 1-Component Portfolio

Having taken a look at the somewhat confusing advice given in the literature about whether to hold short-term or intermediate-bonds in one’s fixed income allocation, I then wanted to do some of my own analysis and number crunching to see how things looked for myself over a time scale I could control.

To do this, I went to Yahoo Finance (the site where I always get my historical pricing data) and downloaded the historical price information for the two Vanguard bond mutual funds shown below:

• Vanguard Short-Term Treasury Fund, Ticker Symbol VFISX.
• Vanguard Intermediate-Term Treasury Fund, Ticker Symbol VFITX.

Whenever I do these types of back-test analyses, I generally like to pick the longest time period I can get access to. In this case, the historical pricing data only went by 16.67 years, to 1996. Therefore, the time period I chose for the analysis was 1996-2013 (present).

First, I wanted to analyze the pure fluctuations/growth of the individual mutual funds (1-component portfolios) over the time period. To do this, I simulated the growth of a $10,000 initial investment in 1996 in each of these funds.

The graph below shows the overall results, where the blue line = Vanguard Short-Term Treasury Fund and the red line = Vanguard Intermediate-Term Treasury Fund. I have also included the growth that would have occurred if the same $10,000 was placed in the Vanguard Long-Term Treasury Fund (green line) and the Vanguard S&P500 Index Fund (purple line).

In general, the chart above shows us some interesting findings.

• Long-Term Treasury bonds have outperformed the equity markets over the past 17 years or so.
• The price volatility appears to be in increasing order of – short-term bonds < intermediate-term bonds < long-term bonds < S&P500 Index, as we would expect.
• Intermediate-Term Treasuries have significantly outperformed Short-Term Treasuries the past 17 years or so.

To add some definite numbers to the performance of the 1-component portfolios shown in the chart above, I generated the table below, displaying year-to-year, month-to-month, and total return data for the 1996-2013 holding period.

If we specifically compare the Short-Term Treasury Fund to the Intermediate-Treasury Fund, we see the following things:

• Intermediate-Term Treasury Fund resulted in a 46.2% and 72.9% increase in average annual and total return, respectively, compared to Short-Term Treasuries. 
  • However, this increase in return only came at the cost of a 25.2% increase in standard deviation of annual return, indicating that the Intermediate-Term Treasury Fund is more efficient in terms of risk/return trade-off.
• Another noteworthy finding is what I found in terms of the minimum annual and monthly returns for the two funds.
  • What we find is that at the annual level (cells highlighted in blue above), the Short-Term and Intermediate-Term Treasury Funds have practically the same return minimum.
  • However, at the monthly return level (red text above), the Intermediate-Term Treasury Fund has a minimum return almost 4x more negative than the Short-Term Treasury Fund.
  • What this means is that even though the Intermediate-Term Fund might be more volatile in the shorter term, over a year, the volatility has tended to equal out over a year-long period.

Conclusion from 1-Component Portfolios – From this analysis, I think we can conclude that although the Intermediate-Term Bond Fund is more volatile at a monthly level, it is more efficient in terms of risk vs. return  than the Short-Term Bond Fund. 

Short-Term vs. Intermediate-Bonds in a 2-Component Portfolio

While examining the “personality” of an asset class in the isolation of a 1-component portfolio is interesting, an even more important thing to look at is how the fund will perform when mixed in as part of an investor’s real life asset allocation.

To investigate this activity, I simulated the growth of the same $10,000 initial investment from 1996-2013 (present) using a 70% Vanguard S&P500 Index Fund equity allocation and 30% fixed income allocation utilizing either the Vanguard Short or Intermediate-Term Bond Funds mentioned above.

The growth of the $10,000 initial investment in the various 70/30 2-component equity/fixed income portfolios  can be seen in the graph below, where the blue line = using the Vanguard Short-Term Treasury Fund, red line = using the Vanguard Intermediate-Term Treasury Fund. For reference, I have also included the growth that would have occurred if the Vanguard Long-Term Treasury Fund (green line) was used for the 30% fixed income allocation and if the Vanguard S&P500 Index Fund was used by itself (100% equity, no fixed income – purple line).

As we might expect, utilizing the Long-Term Treasury Fund for the 30% fixed income portion of the portfolio results in higher performance than using the Short or Intermediate-Term Treasury Fund. Interestingly, it also results in out-performance of the 100% equity portfolio during the time period as well.

The table below shows the year-to-year total return data for the 1996-2013 holding period utilizing a 70/30 fixed income/equity allocation of the 2-component portfolios.

If we focus in on the cells highlighted in blue on the table, we see something rather intriguing. Moving from the use of the Short-Term to Intermediate-Term Treasury Fund as the fixed income portion of the portfolio results in a 10% increase in average annual return, but the exact same risk/standard deviation. By using the Intermediate-Term Fund, you also experience a less negative minimum annual return than the Short-Term Fund! This is quite amazing! It would seem that this is a “free lunch,” so to speak

Conclusion from 2-Component Portfolios – Clearly, the results in the table above would indicate that Intermediate-Term Bonds are without a doubt the most efficient at delivering the highest risk-adjusted return. 

However, there are a couple things that hold me back from being so enthusiastic about jumping on the Intermediate-Bond “wagon.”

• The first “red flag” that gives me pause is the seemingly smooth performance of including Long-Term Treasuries as the 30% fixed income portion of the 2-component portfolio above.
  • By including this highly volatile bond asset class, you get almost a 10% increase in average annual return at the cost of only a 4.5% increase in standard deviation.
  • These numbers seem to indicate that the Long-Term Treasury Bond, in this holding period and using this asset allocation, is actually the most efficient portfolio. 
  • This would seem to be in line with Larry Swedroe’s reports in his more recent 2010 book mentioned above.
  • However, as mentioned by the books in the late 1990’s and early 2000’s (a couple by the same author, Larry Swedroe) Long Term Bonds were NOT efficient in that their increased volatility is not adequately compensated by the increase in return. 
  • Because of this, I cannot help but think that this analysis is somewhat tainted by recency bias. What I mean is that due of the great performance of bonds during the 2000’s-present, holding intermediate/long maturity bonds looks “rosier” in this analysis than it actually is if you were to include a longer 20+ year period.
• My other reservation is in regards to the increase in monthly variations in performance of intermediate-term bonds compared to short-term bonds. I’ll discuss this more in the conclusions section below.

If you’re interested in looking through all of the details/numbers of this analysis, you can access the Google Docs spreadsheet by clicking here.

Conclusions, My Current Fixed Income Allocation, and Path Forward

So, after going through all of this investigation comparing short-term and intermediate-term bonds, what’s the overall verdict? Well, I think it can be summed up in a couple lines:

• An investor will be fine holding either short-term OR intermediate-term bonds (or even a mixture of both) as the bulk of their fixed income asset allocation.
  • There are pluses and minuses for each, and it really just comes down to personal preference and what volatility they want their fixed income holdings to have.
• However, I am comfortable concluding that as far as risk-adjusted return goes, intermediate-term bonds are the most efficient, and I believe they will continue to be going forward based on William Bernstein concluding the same thing in 2001 (prior to big run-up in bonds in recent years).

In the interest of putting a personal application to this topic, I wanted to share how this investigation applies to me. I currently use a 70/30 fixed income asset allocation split in my portfolio. Of the 30% fixed income total, 5% of the total portfolio is in TIPS, 10% in cash, and 15% in short-term bonds.

Path Forward – For me personally, the case presented above isn’t strong enough for me to feel the need to swap my current strategy using short-term bonds in exchange for intermediate-term ones. This is due to the fact that I like the fact that my fixed-income portion of my portfolio is “rock solid,” meaning that it doesn’t vary much (for example, the minimum intermediate-term bond fund monthly return was almost an 8% decrease compared to only a 2% decrease for the short-term bond fund). This makes me feel better about focusing on taking risk and improving returns using the equity side of my allocation.

How about you all? What type of fixed income securities do you currently hold in your asset allocation?

What do you think regarding the decision between short-term or intermediate-term bonds? Which would/do you prefer?

Share your experiences by commenting below!