What Kills a Bond Portfolio

Even if everything goes according to plan, we are probably stuck with zero percent on cash for the next few years.

We’ve been in this situation for so long that it almost seems normal, and with some negative interest rates elsewhere around the world, sometimes zero even seems good (actually, it never does, but negative is just so bad).

Earning nothing is so lousy that every once and a while, I look at ultra-short-term bond fund ETFs to see what they are paying. Right now, they yield a little less than a half of a percent, which is terrible except compared to zero.

Bond returns are primarily a function of two things – the length of the term and the credit worthiness of the issuer. There are some other factors, but these are the biggies by a long shot.

As the name implies, ultra-short bond fund ETFs buy very short-term bonds, usually one year or less. Since a money market invests a lot of its funds in the overnight market, going out a year can pick up a little bit of extra yield.

But these ultra-short-term bond funds also take their fair share of credit risk by investing in bonds issued by companies. Typically, they invest in high-quality securities that are highly rated, and most of the time, there is no problem.

Occasionally, though, there is a terrible problem. In periods of market stress, investors find out the hard way that some of these high-quality issuers aren’t as high quality as they thought.

And, sometimes the market for very short-term credit instruments seize up, and don’t trade at good prices (or sometimes, at all).

In our minds, this is the wrong way to invest cash, which is usually set aside specifically to avoid risk.

Granted, most of the time, these stresses don’t exist and things go according to plan. But you’re not earning very much either. So, in our view, the paltry compensation isn’t worth the risk.

Last week, I asked Ryan to look at an ultra-short-bond fund to see if could be a fit. After taking a look, he concluded that it’s not a fit because it still contains a lot of credit risk that we don’t want to take.

What he said in his reply hit me: losses due to duration are made back with higher yields – credit losses are what kill a bond portfolio.

While he was responding to my inquiry about ultra-short bond funds, it applies to bond investing in general.

If you lose money because interest rates go up, you do suffer a loss, but it isn’t a permanent one because along with the loss in capital comes a higher interest rate.

That doesn’t mean that we’re going to run out and buy long-term bonds, but it’s easier to live with the six or seven-year duration that we have because as long as your time horizon is longer than that, you’ll be happy to see rates go higher.

If you need the money in two years, then that duration isn’t right for you, but most of our bond portfolios have a decades-long time horizon, so rising rates would be good news.

Of course, we have some credit exposure in our bond portfolios too, but it’s well less than half of the bond portfolio. And, it’s highly diversified across issuers. To be fair, that can be true of the ultra-short funds too, but not always.

To be sure, the bond funds that we own have both term and credit risk, and we know that bonds can and do lose money from time to time. But we also know that the losses are limited compared to stocks, which is what makes them a good ballast in a portfolio.

Cash, on the other hand, should be about as free from risk as it can be since that’s the money that you depend on through all market environments.