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The Increasing Risks of Bond Index Funds

NEW YORK (TheStreet) -- Most bond ETFs have sunk lately. This year Vanguard Total Bond Market (BND) has dropped 4.6%, while iShares Barclays 20+ year Treasury Bond (TLT) fell 12.5%, according to Morningstar. Rising interest rates have caused the damage. When rates rise, bond prices tend to fall as investors dump existing issues with low yields.

There have been other episodes when bond ETFs recorded red ink in the last three years, but the latest downturn was especially sharp, says Morningstar analyst Kevin McDevitt. He says that damage was severe because the Barclays Capital U.S. Aggregate and other benchmarks have changed. "The bond benchmarks are more sensitive to rate movements now than they were in 2010," he says.

What has made the ETFs prone to losses is that the benchmarks have come to include more bonds with longer maturities. The longer securities tend to suffer big declines when rates rise. To appreciate how the benchmarks have shifted, consider the Barclays Capital U.S. Aggregate, which covers the universe of investment-grade corporate and government issues. When the market includes more long bonds, then the benchmark must hold them.

In recent years, the Treasury decided to issue more long bonds because interest rates were low. By selling a 30-year bond, Washington could lock in puny rates for decades. As a result, the average maturity of federal debt increased from four years in 2008 to 5.3 years in 2012. Corporate issuers have also brought out more long bonds.

Because it includes more long bonds, the Barclays benchmark is more sensitive to changes in interest rates as indicated by a measure known as duration. In 2009, the benchmark had a duration of 3.7 years. So if interest rates rose by 1 percentage point, the benchmark would lose about 3.7%. Now the duration is 5.4 years.

The impact of the increased duration became clear in May this year. For the month, the yield on 10-year Treasuries climbed from 1.66% to 2.16%, an increase of 50 basis points (0.50 percent). As a result, iShares Core Total U.S. Bond Market (AGG), which tracks the Barclays Aggregate, lost 2.0%. In comparison the yield on 10-year Treasuries climbed 100 basis points during the six months ending in March 2011. But because the duration was shorter then, the ETF only lost 1.4%.

To prepare for an era of rising rates, you could consider ETFs with shorter durations. A solid choice is Vanguard Short-Term Bond (BSV), which has a duration of 2.72 years and lost only 0.5% in May. Another approach is to buy actively managed mutual funds that can shorten their durations when rates rise. Mutual funds that outdid the benchmarks during the recent downturn include Ave Maria Bond (AVEFX), Frost Total Return Bond (FATRX), Scout Core Plus Bond (SCPYX) and Western Asset Mortgage Backed Securities (SGVAX).

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