Short Term VS Long Term Bond Funds

Earlier this year I put together a list of high quality bond funds for readers to check out. There was a lot of good feedback, but some people questioned why I didn’t include any short term bond funds in my list. More recently reader Carla also asked about my indifference to them.

Well, to be Frank, I would have to change my name.  But rather than doing that I will answer Carla’s question. 🙂

Retirement portfolios are usually associated with long term planning. Short term bonds tend to be less volatile and less sensitive to interest rate movements. But since I don’t plan to sell any time soon, short term volatility doesn’t really affect my bottom line. On the other hand, long term bonds pay a higher interest rate (or coupon) which more than compensates for the higher volatility in the long run. For evidence of this, let’s compare 2 bond funds with different durations.

Comparing Returns of ZCS and ZLC

For consistency purposes we’ll isolate the duration variable and look at the following 2 funds.

• BMO Short Bond ETF (ZCS)
• BMO Long Bond ETF (ZLC)

Both funds are from the same company, and hold corporate bonds. The only key difference is the duration of bonds they hold. Below shows the annual total return of these funds from Morningstar, highlighted in yellow.

As we can see, over the last 5 years the short term bond index fund (ZCS) returned only 2.21% per year. The latest inflation rate number from Statistics Canada is 2.2%. So holding a short term bond fund such as ZCS would have earned an annual real return of 0.01%. I think we can all do better than that. 🙂

Meanwhile the long term bond fund (ZLC) returned 6.21% per year on average. Even the 1 year return shows that long term bond fund ZLC came out ahead. Keep in mind this is during a rising interest rate environment, which should hurt long bond funds more. But short bond fund ZCS currently has a weighted average coupon of only 2.91%, while ZLC’s is at 5.29%. The longer investment time horizon we have, the bigger the difference in returns we should see between ZLC and ZCS. 🙂

This is why I stay away from more mainstream bond funds such as the BMO Aggregate Bond Index ETF (ZAG.) By looking at the fund, I discovered that 47% of the ZAG’s top 10 holdings by weight are short term bonds. I don’t want nearly half of my fixed income portfolio to earn effectively zero return after inflation, lol. So even though it’s recommended by the Canadian Couch Potato as the best bond fund to have, ZAG just doesn’t do it for me.

Of course there is a time and place for everything. Like Carla mentioned above, short term bond funds perform better when interest rates are going up. In the past 3 months BMO’s short bond fund ZCS lost only 0.04%, while its long bond fund ZLC lost 1.88%. The BoC hiked rates twice during that period. This means short term bonds can outperform long term bonds, but only if we look at a relatively short time horizon during rising interest rates. We can apply the same logic to medium term bond funds. They might do better than long term bonds over the next couple of years. But a buy-&-hold investor who’s committed for at least 3 years should probably just go 100% long.

So if we plan to stay invested for multiple years, the advantage of higher coupon rates on long term bonds should outweigh the temporary stability of short term bonds. Rising interest rates hurt longer bond funds more in the immediate future. But at the same time it also means newly added bonds to these funds will distribute higher returns, which makes it more profitable in the long run. 🙂

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Random Useless Fact:

There are minimal carbs in brussel sprouts, which makes them a great addition to a keto diet.