Short-Term Bonds: Why They Could Outperform As Interest Rates Rise

Key Points

  • If the Federal Reserve continues to increase short-term interest rates, bonds and bond funds with shorter maturities may outperform intermediate- and long-term bonds.
  • Short-term bonds may offer more upside potential with lower risk in a rising-rate climate than long-term bonds.
  • However, a lower starting point for rates during the current rate-hike cycle could mean lower returns compared with historical averages.

After years of underperforming their longer-term counterparts, bonds with shorter durations appear ready to reverse the trend.

Bonds with intermediate or longer maturities—or with higher credit risk—have outperformed short-term bonds, on average, since the early 1980s. Moreover, yields on bonds with very short maturities were near zero from 2008 to December 2016. That’s when the Federal Reserve raised interest rates for just the second time in the past decade.

We expect that the Fed will raise interest rates two to three times in 2017, based on rate projections the central bank reported in December. Historically, bonds with shorter maturities have delivered better performance with lower risk in a rising-rate environment than bonds with longer durations. As such, we believe investors should consider adding short-term bonds or bond funds to their portfolio.

Aren’t rising rates bad for bonds?

When interest rates rise, the value of existing bonds generally fall. But shorter-term bonds are less sensitive to rising rates, in general, than intermediate-term and long-term bonds. 

Ultimately, rising rates can be good for bond investors who keep duration short to intermediate (three to five years) on average, and reinvest the proceeds from maturing bonds into newer, higher-yielding bonds as rates move up. Yield drives most of the return on bonds—on short-term bonds, in particular, because there’s not as much room for prices to change. Rising rates can help bond investors who are looking for income, but maturities should be closely watched. With rates on the rise, we believe short-term bonds offer good risk/reward trade-off now.

Returns from short-term bonds on average trail bonds with longer maturities

In the U.S., interest rates rose sharply in the late 1970s and early 1980s, but have declined steadily for the last 35 years. This has led to a bull market in bonds, especially those with longer maturities. But as short-term rates fell, so did the average returns, driven mostly by falling interest payments, from short-term bonds. That’s shown in the chart below, which reflects returns from U.S. government and corporate bonds with maturities between one and three years.

Short-term bonds’ average annualized returns have trended lower since the early 1980s

Source: Bloomberg Barclays US Government/Credit Index, annual total return (interest payments plus change in price) through 12/31/2016. Past performance is no guarantee of future results.

The chart below compares these returns—on average, annualized—to U.S. government and corporate bonds with intermediate (five to 10 years) or long-term (10+ years) maturities. The higher rates for longer maturities, coupled with rising prices, have resulted in higher average annualized returns from intermediate-term and long-term bonds over various time periods.

Bonds with intermediate- and longer-term maturities have outperformed on average

Source: Bloomberg Barclays. Chart shows average annual return and highest and lowest 12-month rolling return, as of 1/25/2017. Past performance is no guarantee of future results.

This makes sense. In general, investors expect to be paid more for higher risk—which includes bonds with longer maturities. In rising-rate environments, though, short-term bonds—or portfolios including short-term bond funds—have delivered strong risk-reward trade-off relative to bonds with longer maturities

The risk was lower in short-term bonds, as indicated in the chart below. The chart shows the average annual returns in areas of the U.S. bond market and the best and worst one-year return. (Note that we could have substituted tax-exempt municipal bonds with varying maturities and the results would have been similar. The worst 12-month return for one- to three-year U.S. government and corporate bonds, in addition, was still positive.)

Risk—and return—were lower in short-term bonds

Source: Bloomberg Barclays. Chart shows average annual return and highest and lowest 12-month rolling return. Data from 1/31/1978 to 12/30/16. Data for the S&P 500® Total Return Index is from 1/29/1988 to 12/30/2016. Past performance is no guarantee of future results.

The story changes when short-term rates are rising

But what if we look at returns only during periods when short-term rates were rising? What impact has that had on the performance of short-term bonds?

To find out, we looked at multi-year periods over the last 40 years where the two-year Treasury yield was in an upward trend. Since 1985, there have been five such periods, highlighted in gray below, including the period that started in late 2013.

Since 1985, the two-year Treasury rate has trended higher across multiple years on five occasions

Source: Bloomberg, two-year constant maturity U.S. Treasury yield, through 12/30/2016. Past performance is no guarantee of future results.

The chart below shows the return on short-term bonds during those five periods was greater on average than government and corporate bonds with longer maturities.

Short-term bonds often beat total returns for intermediate-term bonds when yields are rising

Source: Bloomberg Barclays. Chart shows total return (interest payments plus change in price), during extended periods when two-year Treasuries rates were rising. Past performance is no guarantee of future results.

Short-term bonds outperformed in four of the five periods, with the exception being the current November 2013-to-December 2016 period.

The chart below shows the average annualized returns combining those time periods.

Average annual returns for short-term bonds beat other sectors on average

Source: Bloomberg Barclays. Chart shows total return (interest payments plus change in price), during extended periods when two-year Treasuries rates were rising More specifically, the chart shows the average annualized returns during these five time periods: August 1986 to March 1989, August 1993 to December 1994, October 1998 to April 2000, May 2003 to June 2006 and November 20013 to December 2016. Past performance is no guarantee of future results.

What about the risk? In periods when rates were rising, short-term bonds, on average, delivered 122% of the returns of intermediate-term bonds with only 46% of the volatility. Over all periods, short-term bonds have delivered 83% of the returns of intermediate-term bonds with 54% of the volatility.

In short, shortening duration, and adding short-term bonds or bond funds to a fixed income portfolio may make sense if you expect, as we do, that short-term rates will continue to rise.

What may be different now: the low starting point for short-term rates

It’s important to keep the current climate in mind and the numbers above in perspective. One of the reasons for the lower performance in the 2013-to-present period is that short-term rates started out much lower—near zero, in November 2013. The low-rate environment today, clearly, is different than it was historically.

The average yield for a portfolio of U.S. government and corporate bonds maturing in one to three years —or a short-term bond fund that holds similar bonds—is just more than 1% today. A municipal bond portfolio with similar maturities today would deliver a similar yield before taxes.

Going forward, returns will likely be lower than they were historically. Also, while we believe that short-term rates will rise, the performance of the U.S. economy and other factors could affect that outlook. Still, when building bond portfolios, we believe that the risk/reward trade-off for short-term bonds in your portfolio is positive now.

What to do now?

Shorten the duration of your portfolio.  Do you own individual bonds or bond funds? What are the average maturities of the bonds you own or the bonds in your bond funds? Today, we suggest average portfolio maturities for most investors of between three to five years, with a mix of short- and intermediate-term bonds.

If you’re not sure how to calculate the duration of your bond portfolio, Schwab can help. Call a Schwab bond specialist at 877-908-1072, or talk to a Financial Consultant at your local branch.

For help in choosing short-term bond funds, see the Schwab Mutual Fund OneSource Select List®. Choose Taxable or Tax-Free Bond funds, and look for funds with the Morningstar Category “Short-Term Bond.” 

Schwab clients also can review the maturities in their bond fund portfolios by logging in at Schwab.com (navigate to “Portfolio Performance,” then “Schwab Portfolio Checkup/Portfolio Analysis”, then click “Fixed Income.” The “Time to Maturity Section” on this page will show the percentage of your fixed income holdings by maturity date period.)

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

   Was this helpful?  

Subscribe:

Subscribe to Emails Subscribe via RSS

Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Charles Schwab & Co., Inc. (member SIPC) receives remuneration from fund companies in the Mutual Fund OneSource® program for recordkeeping and shareholder services, and other administrative services. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services