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TheStreet Open House

Don't Get the 'Short End' of the Stick

Stock quotes in this article: TLT, SHY, BSV

NEW YORK (TheStreet) -- Nervous investors plowed into bonds of all shapes and sizes in 2009-2010, but only over the past year or so has duration become a primary concern.

Interest-rate risk is amplified the further out one goes on the yield curve -- meaning, shorter-term bonds ought to have less price sensitivities in a rising interest rate environment. Pricing for longer-term bonds (those that don't mature for 20 years or more) will be more sensitive to interest rate fluctuations since the term over which they pay interest is longer.

We are seeing advice and commentary all over the financial media about shortening up the duration of fixed-income portfolios. The party line goes something like this: By reducing your exposure to the long end of the yield curve, you are taking a huge step towards protecting your fixed-income portfolio against the threat of rising rates.

In theory this makes good sense. But let's take a look at why it may not actually be adding much value in practice.

Time to Adjust Your Risk-Adjusted Return Expectations

In addition to short-term interest rates being artificially pegged near zero (the Fed Funds rate has been 0.25% since December 2008), the "shorten-duration" trade has further inflated prices (and depressed yields) in the market for these securities. My point isn't that short-term bonds are riskier than long-term. It is simply that there is risk in owning short-term paper, too, and the measly interest with which investors are currently rewarded is not worth taking that risk.

Duration is the measure of how much a bond fund or portfolio will rise or fall due to changes in interest rates. A bond fund with a duration of two years will lose 2% of its value when interest rates rise by 1%.

The iShares 20+ Year Treasury Bond ETF (TLT) has a duration of over 16 years and currently yields 3.15%. That means you are risking five years' worth of interest should rates rise by 1%. Clearly an unattractive risk/reward but how much better will it get by shortening our duration?

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