Short-term bond funds aren't so short

By DAVID MOON, Moon Capital Management, LLC
April 25, 2010

The typical automobile windshield is 1,800 square inches. A standard rear view mirror is 48 square inches. That may represent how most people drive, but it’s not generally how we live.

Most of us spend way more energy looking backward than we do looking frontward. We are consumed with the way things have been.

Too many people think the past equals the future.

The frustrating thing is that even for the people who think independently and successfully identify future risks – as opposed to historic risks – it may not always be easy to access the information necessary to take successful evasive action.

Such is the case with conservative-minded bond-fund investors.

You’ve heard that bonds reduce risk. That is generally true as long as interest rates are stable or declining. When rates are steady, bonds provide a predictable income stream, reducing the volatility of portfolios.

When interest rates increase, however, bond prices decline. The longer the maturity of the bond, the more likely it is to significantly decline in price when interest rates rise.

Investors who are relying on bond portfolios to provide risk reduction in the future, however, may be in for a surprise. Short-term interest rates are near zero. They certainly aren’t going to decline from here, nor will they remain at these levels indefinitely. They will eventually increase, and when they do, investors who own bonds, particularly long-term bonds, will experience capital losses.

From 1963 to 1969 the S&P 500 returned a total of 82 percent. How did conservative long-term government bonds do during this 7-year period?

They dropped 33 percent. Long-term bond prices are generally quite volatile relative to changes in interest rates.

That’s why many forward-looking investors own short-term bond funds, as opposed to the longer, more volatile variety.

At least they think they do.

The problem is that many “short-term” bond funds aren’t short-term at all.

The Securities and Litigation Group in Fairfax, VA conducted a study of short and ultra short-term bond funds. They found that in early 2008, the average maturity on the so-called ultra short-term bond funds was over 17 years.

Yes, years; not months.

The funds were able to get away with calling themselves “short-term” by using things called Macaulay and modified duration, and then predicting that the prices of the bonds in these funds might act like short-term bonds if interest rates increase.

That’s the same type of process that investment bankers used to combine a bunch of sub-prime mortgages into a single security and call it “high-grade”.

Many investors who are trying to minimize their risks by owning bonds that shouldn’t drop dramatically in reaction to higher interest rates are doing the opposite. Most of them don’t even realize that they actually own long-term bonds.

If a bond fund owns a bunch of 20-year bonds, it is not a short-term bond fund.

If you have three dogs and call one of them a cat, how many cats do you have? None, because calling a dog a cat does not make it a cat.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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