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http://ifa.com - http://ifarcs.com - http://ifabt.com - The Dimensions of Bond Returns: Term and Default Risk

Bonds are a component of investment portfolios because they dampen the volatility of stocks due to their low correlations to movements of stock prices. Bonds also provide short-term liquidity to investors with cash needs over a two to five-year period.

There are two primary risk factors that explain bond returns. The first is the term factor, which is the difference between the returns of long-term government bonds and short-term Treasury bills. The annual average return for the term risk factor has been 2.03% for the 82 years from 1928 to 2009.

While the term provides higher expected returns, the excess returns diminish significantly beyond a term of five years, so bonds with terms of more than five years should be avoided.

If investors keep terms or maturities short and default risk relatively low, they have more opportunity to capture the much higher expected returns from the size and value risk factors of stocks.

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