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Should you avoid long term bonds?

July 4, 2012 - 0 comments

In a 2009 article written by Larry Swedroe and Kevin Grogan called, “The Maturity of Fixed-Income Assets and Portfolio Risk”, the authors examined the impact of extending bond maturities for various equity allocations. They found that at low fixed income (high equity) allocations, the equities were the dominating factor in the portfolio’s volatility. In other words, investors with high equity allocations could extend the maturities of their fixed income (increasing their expected returns) without significantly increasing the volatility of their portfolio. The reverse was also true; at high fixed income (low equity) allocations, the fixed income was the dominating factor in the portfolio’s volatility. Investors looking to reduce the volatility of their portfolio would be required to reduce the maturities of their fixed income.

I ran a similar analysis from 1980 to 2011 using historical Canadian fixed income and equity index returns. The equity allocation for each portfolio was split evenly between the S&P/TSX Composite Index, the S&P 500 Index and the MSCI EAFE Index. I used the following bond indices to demonstrate the impact of extending maturities:

  • DEX Short Term Bond Index (Short Term Bonds)
  • DEX Universe Bond Index (Broad Market Bonds)
  • DEX Long Term Bond Index (Long Term Bonds)

The analysis produced similar results to the above study. For higher equity allocations (i.e. 80% equity / 20% fixed income), extending the maturities of the fixed income did not drastically increase the volatility of the portfolio. For lower equity allocations (i.e. 20% equity / 80% fixed income), extending the maturities increased the volatility of the portfolio dramatically. I’ve illustrated the results in the graph below:

Standard Deviation of Various Equity Allocations: 1980–2011

Sources:  Dimensional Fund Advisors, Morningstar EnCorr

Conclusion

When deciding on how far to extend your fixed income maturities, your risk tolerance should be the main driving factor.  However, if your tolerance is high (and you also have a relatively high equity allocation), you should consider taking more maturity risk with your fixed income allocation.


 

By: Justin Bender with 0 comments.
Filed under: Fixed Income
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