EC Should Investors Be Cautious On Short Term Bonds?

After seven years the Federal Reserve finally did the unthinkable by raising the Fed Funds rate by 25 basis points. For years I’ve heard many investors and professionals talk about moving money into short term bonds because of the risk of rising rates and the eventual end of the great bond bull market.

While I generally agree with the overall sentiment here, it’s a given that interest rate sensitivity is greater as the duration gets longer. The problem is that each end of the yield curve doesn’t always move in unison. So by over allocating to the short end of the curve, investors may very well be piling into the same end of the curve that might be most effected by a gradually rising Fed funds rate.

In fact if you tell me that we are going to continue to see sluggish economic growth in the 2% range while the Fed funds rate gets lifted, I’d say there is a good chance the long end of the yield curve won’t move nearly as much as the short end, effectively flattening the curve.

If you tell me economic growth is going to pick up above 3% for the foreseeable future, then I’d be more inclined to be cautious on the long end as well. However economists and fed forecasts have been predicting a stronger pickup in real GDP growth since 2012, and so far it’s been spotty at best.

So what I’m saying is that I don’t feel investors are getting compensated enough for the risks they take in short term bonds and short term bond funds. I’m sure this is a contrarian opinion.

2_yr.png

Let’s take a look at the last 16 months as an example. I understand that it’s a very small sample size, but it helps illustrate the overall thesis.

The above chart is the yield on 2 year treasury bonds. From October 2015 into the end of the year, in anticipation of the first Fed funds rate hike, the yield went from 0.57% to 1.09%, for an overall increase of 91%. During the rally in equities off the February 2016 lows, the 2 year treasury yield went from 0.64% to 0.98%, for an overall increase of 46%.

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Disclosure: Nothing on this article should be misconstrued as investment advice. Trading and investing is very risky, please consult your ...

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Alexa Graham 4 years ago Member's comment

You've proven your case well.

Michael Gouvalaris 4 years ago Author's comment

Thanks for reading Alexa, I appreciate that.