The Term Factor

Fundamentals of Market Investing by Adam J. McKee

This is one of the very few factors that apply to something besides stocks.  The term premium refers to the extra money you get when you hold bonds with maturity dates far out in the future versus bonds with very short maturity dates (e.g., one month).  It is very persistent over time, if not very large.  We have bond data for a very long period, and we know the premium is about 2.5%.  We already know that bonds have a low correlation (negative at times) are very commonly used as a hedge against market volatility (beta).

A common factor associated with bonds is the idea of default risk.  This risk factor means that the credit rating of the bonds should have a big impact on the profitability of holding those bonds.  Research has shown that this is not necessarily the case.  Corporate bonds tend to be linked to appraisals of the prospects for the company, and so do stock valuations.  Corporate bonds, then, tend to correlate with market returns, especially in bad economic times when the outlook is bleak.  Higher risk bonds to return higher percentages in isolation, but the risk-adjusted returns in a portfolio with beta exposure are not very good at all.  Simply put, corporate bonds do not do a good job of hedging stock market risk.

Given the behavior of bonds and their traditional rates of return, they should only be used when volatility matters, such as in a retirement account where you depend on regular withdrawals to make ends meet.  If you do plan to use them as a hedge against stock volatility, I suggest taking advantage of the term premium as much as possible.  All bonds are subject to inflation rate risk, and rising rates tend to hurt long-term bonds more than intermediate and short-term bonds.  If you want to smooth out volatility of all sorts, I suggest that you split your bond allocation between intermediate-term and long-term bonds issued by the US Treasury.

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Last Updated: 6/25/2018

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