THE LOW RATE CONUNDRUM

Why Shorter-Term Bonds Make Sense Right Now

Eric Gerster

SUMMARY• The Fed is poised to raise rates for the first time since the financial crisis,

placing fixed income investors in a difficult position.

• Shorter-term bonds/bond ETFs make more sense now.

• The low level of rates across the yield curve means investors choosing longer duration bonds/ETFs could have less money in 5 years than they do today.

• Choosing shorter-duration bonds/ETFs allows investors greater protection of principal while increasing investment flexibility in a Fed tightening scenario.

• The U.S. Federal Reserve (Fed) has signaled that it intends to raise interest rates this year for the first time since before the financial crisis of 2008.

• This will take short-term rates up from the zero bound on a path to more normal rates.

• Recall that as interest rates go up bond prices go down.

• Fixed income investors are presented with a challenging dilemma.

• Many have reached for yield by buying longer duration bond funds, bond ETFs or outright bonds.

• Assuming a move in short-term rates lead to a similar increase in long-term rates this strategy will be painful.

• This is especially true because yields are so low that the interest earned on these longer duration fixed income assets cannot compensate for even a modest increase in rates.

• As I will demonstrate with several examples below, an investor in a longer duration fund or ETF could easily have less money 5 years from now than they would start with today.

• On the other hand, the investor in a shorter duration fund or ETF has two benefits.

• One, they will lose less principal as rates rise because the duration is shorter, and two they will have the option of moving to longer duration assets as rates rise.

EXAMPLES USING COMMONLY TRADED ISHARES ETFS. (SHORTEST DURATION

TO THE LONGEST)• As you can see from the table on the next slide, the iShares Short-Term

National AMT-Free Municipal Bond ETF (NYSEARCA:SUB) has a fairly short duration of just 2.03 years and a low distribution yield of 0.85%.

• Assuming the Fed raises rates fairly cautiously for the next several years and all interest income received is reinvested, the investor in this example will have just over 5% more money invested at the end of 2019 vs. his starting investment with a Compound Annual Growth Rate (CAGR) of .99%.

• Additionally, at the end of this period, he will be earning a 3.6% yield on his principal assuming the fund is able to reinvest in higher short-term yields as its bonds mature.

• Now moving on to a medium duration bond ETF, we examine the impact from our rate increase scenario on the iShares National AMT-Free Municipal Bond ETF (NYSEARCA:MUB).

• As you can see in the table, the duration of this fund is more than double SUB, at 4.75 years, while an investor in the fund received 2.63% annualized in its most recent distribution yield.

• Using my same rate increase example as in SUB and again assuming all interest income is reinvested, this investor will have just over 6% more money invested at the end of 2019 with a CAGR of 1.24%.

• Keep in mind that a more aggressive rate rise scenario makes this CAGR fall as the fund cannot reinvest fast enough to offset the principal loss.

• Finally let's look at what happens if an investor extends duration more dramatically.

• The iShares Core 10+ Year USDollar Bond ETF (NYSEARCA:ILTB) has a duration of 13.32 years and a distribution yield of 4.22%.

• Seems like a good deal to get this 4.22% if you are an investor in need of yield.

• Unfortunately the starting point of the absolute yield is low and a rate rise scenario is painful.

• As we see in the table below, after 5 years, this investor has lost nearly 10% of his original $1,000,000 investment despite reinvesting all interest payments.

• This works out to a negative CAGR of -2.1% over this time period.

MAJOR TAKEAWAYS• Assuming a relatively gradual increase in the Fed Funds rate over the next 5 years, it

pays to be invested in shorter-duration bond funds and ETFs at this time. An investor in a fund with a duration over 10 years is particularly vulnerable to rate increases.

• Investing shorter-term now provides investors with the flexibility to increase duration (and improve yield) as rates rise.

• These examples assume a uniform increase in rates across the term structure. I understand that many fixed income experts expect interest rates to move more in the 2-5-year range than in the very short or very long end of the yield curve. However, I don't know how rates will move and I want to take a conservative approach. If I am wrong, then I am still likely better off investing short duration for the near term. I have the flexibility to adjust.

• The current historically low interest rate environment presents significant challenges for investors who need to generate income from their principal.

• However, the high degree of likelihood that the Fed begins raising rates later this year suggests shorter duration makes sense at this time.

Magnolia Lane Financial Advisors, LLC is a Registered Investment Adviser. Custody services and other brokerage services provided to clients of Magnolia Lane Financial Advisors, LLC are offered through Charles Schwab & Co., Inc., member FINRA/SIPC/NFA. This article is

solely for informational purposes. Advisory services are only offered to clients or prospective clients where Magnolia Lane Financial Advisors,

LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Magnolia Lane Financial Advisors, LLC unless a client

service agreement is in place. !

-Eric Gerster

Thank you for viewing my presentation. Please check back again soon for more information.