Long-Term Versus Short-Term Bonds

It is important that bonds form an integral part of your portfolio. There are at least two reasons for this. First, bonds are substantially less volatile (risky) than equities and second, they tend to fluctuate independently of the equity prices. In other words, the correlation between bonds and stocks is very weak. This means that in times of stock market woes bonds can save your quiet sleep.

However, the question when investing passively is whether to hold all bonds or just some maturities. One would think that long-term bonds (20-30 years) would earn higher returns than short-term bonds (1-5 years). Why? Because the uncertainty if the issuer is still up and running 20 years from now is higher than the uncerainty 5 years from now. I can also imagine that long-term bond markets are less liquid than short-term bond markets. As a result of that, investors should require higher risk premium for long-term bonds and thus earn higher returns over the time.

Nevertheless, the reality seems to be different. Me and a couple of US companies advising people on how to invest passively recommend investors to restrict their bond portfolios to bonds with maturities from 1 to 5 years.  Why? Because historical data shows that the returns associated with long-term bonds do not offset the risks (volatility). Short-term bonds (1-5 years) tend to generate simliar returns with a lot less volatility. You can see it also below in the picture from the Credit Suisse Yearbook.


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