Right Financial Plan: Short-Term Vs. Long-Term Maturities

Short-term bonds have the benefit of less volatility and lower correlation to equities. Long-term bonds should provide higher returns to compensate for the additional risk. The question is whether investors are compensated for taking on additional risk by extending the maturity of fixed-income assets. We evaluated the use of short-term bonds (one-year Treasuries), intermediate-term bonds (five-year Treasuries) and long-term bonds (twenty-year Treasuries), finding that the most efficient maturity depends on the investor's overall asset allocation.

For portfolios with the commonly used allocation of 60 percent equities (split 60 percent domestic and 40 percent international)* and 40 percent bonds, the highest Sharpe ratio (risk-adjusted return) has been achieved with five-year Treasuries. Extending maturities to twenty years produced higher returns, but a lower Sharpe ratio (a result of their higher volatility and higher correlation to equities). While risk-seeking investors might prefer the portfolio with long-term bonds, most investors are risk averse.

Short-term bonds have less volatility and lower correlation to equities than long-term bonds. Shifting from long-term to short-term does not allow an investor to increase the Sharpe ratio by increasing the equity allocation to achieve higher returns with the same volatility. The shorter maturity does not allow the investor to take more risk on the equity side of the allocation.

Another thing risk-averse investors should consider is that the longer the maturity, the longer "left tail" (larger losses) in the distributions of annual returns.

The Results at Different Equity Allocations The appropriate maturity varies depending on the equity allocation. At equity allocations below 80 percent, five-year Treasuries produced the most efficient portfolios, though long-term bonds produced the portfolios with the highest returns. At high equity allocations (80 percent or higher), the portfolio with long-term Treasuries produced the highest return and highest Sharpe ratio.

At high equity allocations, the higher returns from longer-term bonds dominate the effect of the higher standard deviation: The volatility of equities is the dominant factor in the portfolio's volatility. At high fixed-income allocations the reverse is true: The high standard deviation of longer-term bonds dominates the higher returns.

Tomorrow, we'll look at reasons to reduce maturity risk and to increase maturity risk.

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* Domestic equities are represented by the S&P 500 Index, and international equities are represented by the MSCI EAFE Index.