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Yesterday’s post on Re-Thinking High Yield Fixed Income garnered some insightful comments from a reader (Returns Reaper – love the name!). Further to that, I thought I would bring up some data and perspective on how extending bond maturities does not provide a good risk-adjusted return payoff. The following chart (please click to enlarge) shows the returns of US Government fixed income securities from 1964 to 2007, along with their standard deviations (a measure of the volatility or variance in returns). What is evident is that while returns increase marginally with longer terms, the volatility increases dramatically. (Many thanks to DFA Canada for providing this graph.)
Click on graph to enlarge
One possible explanation is that longer term bonds are used primarily for the purpose of matching assets to liabilities. This would fall into the realm of pension plans and insurance companies (who have death benefits to pay out many decades into the future but who build in actuarial calculations based on current interest rates and other factors). For them, their definition of risk is “not having the money to pay their obligations in their entirety”. Having and holding long term bonds with known maturity values is their prime concern, not trading these instruments to make gains over and above what they need.