Leave Bond Ratings Behind. This Is the Major Fixed-Income Threat.

Understanding the True Risks in Bond Portfolios

Investors often believe that the primary risks in their bond portfolios come from default risk or the country of origin of their investments. However, a deeper analysis reveals that the main source of risk is actually the time to maturity of the bonds or bond funds they hold.

To explore this issue, researchers examined U.S. dollar-denominated fixed-income mutual-fund data spanning 40 years. They analyzed average monthly returns across several fixed-income groupings, including short-term Treasury funds, long-term Treasury funds, intermediate Treasury funds, world debt funds, high-yield corporate debt, and investment-grade corporate debt. Each grouping had different average maturities, allowing for a comprehensive comparison of risk levels.

Measuring Risk in Fixed-Income Investments

Two key measures were used to assess risk: volatility, defined as the standard deviation of monthly returns, and the interquartile spread, which reflects the difference between the 75th and 25th percentiles of returns. A wider spread indicates higher risk.

One of the most significant findings was the stark difference in risk between long-term and short-term U.S. government debt. Over the past 40 years, the annualized volatility for long-term Treasurys was 8.04%, compared to just 1.10% for short-term Treasurys. This represents a difference of 6.94 percentage points in volatility, making it the largest risk disparity observed in the study.

The interquartile spread further confirmed these findings. For long-term U.S. government debt, the spread was 2.55 percentage points, while for short-term debt, it was only 0.45 percentage point. The gap between the two was 2.10 percentage points, reinforcing the conclusion that longer maturities carry significantly more risk.

Country of Origin and Credit Quality

Next, the study explored the impact of the country of origin on risk profiles. When comparing the average world bond portfolio with intermediate U.S. government debt, the volatility for world bond funds was 7.20% annually, compared to 4.62% for intermediate U.S. government bonds. This difference of 2.58 percentage points highlights the increased risk associated with global debt holdings.

Similarly, the interquartile spread between the two groupings was 0.70 percentage point, showing that geographic diversification does not necessarily reduce risk as much as other factors.

The research also looked at the difference between investment-grade and high-yield corporate debt, ensuring that both groupings had similar maturities to isolate credit quality as a variable. High-yield corporate debt showed an annualized volatility of 7.51%, compared to 5.80% for investment-grade debt. This 1.71 percentage point difference underscores the higher risk associated with lower credit quality.

A Real-World Example

A tangible example of these risks can be seen in 2022, when the Federal Reserve raised interest rates by 4 percentage points. During that year, investors in long-term Treasury funds experienced losses of around 30%, while those in high-yield corporate debt funds saw losses of only about 9%. This illustrates how the length of time to maturity plays a critical role in determining the risk profile of a bond portfolio.

Strategic Implications for Investors

With current uncertainties in U.S. markets, investors seeking to minimize risk should consider shifting toward short-dated debt funds—those with maturities under one year. This approach can significantly reduce potential losses during downturns, even more so than adjusting credit quality or exploring international markets.

By focusing on maturity rather than other factors, investors can better manage the inherent risks in their bond portfolios and make more informed decisions about their financial futures.