Are there additional return benefits to investing in longer rather than very short-term, fixed income investments? In this episode of Buckingham Weekly Perspectives, Head of Investment Research Jared Kizer explores the concept of the term premium and why it’s important in fixed income investing and overall portfolio allocation.
Transcript:
Jared Kizer: So today I wanted to talk about the term or maturity premium and kind of unpack what that phrase means and why it’s important for thinking about investing in fixed income and thinking about overall portfolio allocation as well.
What Is a Term Premium?
Jared Kizer: So the term or maturity premium is simply the question of do you see historically additional return benefit going from fixed income investments like money market accounts that are very, very short term that have essentially no interest rate risk because the rates are constantly resetting to slightly longer maturity and fixed income investments like say, five-year Treasury note investments where your money is going to be paid out to you over a five-year period and therefore more sensitive to what rates are doing and how they’re changing over time, as we saw in 2022, where those longer maturity investments did poorly because rates unexpectedly increased by a lot.
Are There Benefits to Owning Short-Term Fixed Income Versus a Longer Maturity?
Jared Kizer: So we’re trying to answer that question of do historically, do we see an additional benefit from moving out of ultra short-term fixed income into slightly longer maturity fixed income? And the historical answer, whether you look in the U.S. market or outside of the U.S. market, is yes. Historically, we’ve seen about 2% of additional per year return on average, importantly from owning, say, four to five-year maturity fixed income compared to Treasury bills or money market type investments. So historically you have seen that additional benefit. And again, I’ll caveat by saying that’s what happens on average, like any source of return is it positive in every single year. Again, very recently, 2022 being a great example of that.
What About Ultra Long-Term Fixed Income?
Jared Kizer: Also going to qualify the answer with one other point that we like to share with people that are trying to dig in, in terms of thinking about how to structure a fixed income portfolio is that while you have seen that benefit going from very, very short-term fixed income, again, like a money market account out to a four to five-year investment, you don’t tend to see a reliable additional benefit by going out even further in maturity of, say, buying 20 or 25-year maturity fixed income. So we’d say it’s a qualified yes, you want to take a little bit more maturity risk generally, but not load up on lots of it as we think a general, a good general approach or one that’s certainly consistent with what the long-term historical experience has been in lots of different markets.
Longer Maturity Investments Offer Diversification Benefits
Jared Kizer: Last thing I note in terms of an argument for taking a little bit of maturity-related risks is that you do tend to see that it provides some benefit relative to the stock side of the portfolio, so when you think about environments whether it’s 2020 or 2008, early ‘09, where the stock market is getting hit really, really badly, very, very negative returns, you’ll tend to see having a little bit of interest rate risk can be beneficial because frequently high-quality fixed income at least will perform well and rates tend to fall in that environment, adding to some additional return there. So this is an important concept also from a diversification point of view. If you have additional questions you’d like for us to tackle, feel free to reach out to your advisor and suggest questions there. Or click the link below and submit questions in that way as well. Thanks.
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Sources: Treasury bond returns sourced from DFA Returns Web.
Jared Kizer, CFA
Jared Kizer evaluates findings from academic research and applies that learning to develop investment strategy recommendations. Jared collaborates daily with advisors and clients, helping investors better understand the complicated concepts that can have a tangible effect on their financial lives. Jared holds a master’s degree in finance from Washington University in St. Louis.
