One of the largest disconnects between financial experts and typical investors centers around the question of bond duration.
Duration is one of the most important characteristics of a bond or a bond fund because it describes how sensitive a bond’s price is to changes in yields.
Bond yields and bond prices move in opposite directions: when the yield goes down the price goes up, and vice versa. Short-term bonds have a low duration, which means their prices don’t move very much when yields change. Long-term bonds have a greater duration, and their prices will change more.
Duration is defined as the average time it takes to receive all the cash flows of a bond, weighted by the present value of each of the cash flows
Although most people understand that the primary function of bonds is to provide fixed income many investors don’t fully realize that the period of time over which that income is “fixed” corresponds to the bond’s duration. One use for duration is to measure the exact period of time over which the bond’s return is completely immune to changes in interest rates.
A 5-year bond provides highly certain income over that five-year period, but highly uncertain income over much longer or much shorter periods of time. Which brings us to to a crucial guiding principle when choosing bond funds for your portfolio:
The safest bond fund has an average duration that matches your investment time horizon.
If your financial goals are primarily short-term, they are best matched using short-term bonds. But if your financial goals are primarily long-term, they are best matched using long-term bonds. This principle is sometimes called “duration matching” or “liability matching”.
A mismatch between bond duration and investment horizon exposes the investor to interest rate risk, which is the chance that an an adverse change in bond yields (either up or down) will reduce their ability to achieve their financial goals.
Because a couple approaching in their mid-60s will typically be planning for a retirement which could possibly last into their 90s they often have a much longer investment time horizon than they assume. Because the average expenditure for them is perhaps 12-15 years in the future, their average bond duration at the beginning of retirement should likewise be 12-15 years.
Younger investors should rationally favor even longer bond durations.
Despite the great popularity of so-called “total bond market funds” like Vanguard Total Bond Market ETF (BND) and Vanguard Total Bond Market Index Fund (VBTLX), most investors under the age of 70 should probably consider having most if not all of the bonds in their retirement portfolios allocated to long-term bonds.
This concept of liability matching was a core part of my CFA training and MBA education at the University of Chicago Booth School of Business.
Examples of funds I recommend do clients are low-cost, highly-diversified bond funds and ETFs such as:
- iShares Core 10+ Year USD Bond ETF (ILTB)
- Vanguard Long-Term Treasury ETF (VGLT)
- PIMCO 15+ Year US TIPS ETF (LTPZ)
- Vanguard Long-Term Tax-Exempt Fund (VWLUX)
These are often combined with shorter duration funds to get the right duration for every stage of the financial plan. Every fee-based or advice-only financial planning engagement will include an expert review of your bond duration and investment horizon.