This Day On The Street
Continue to site
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

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.

[Read: <a target="blank" data-add-tracking="true" href="http://www.thestreet.com/story/12024491/1/taking-advantage-of-telecom-sector-consolidation.html"><em>Taking Advantage of Telecom Sector Consolidation</em></a>]

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%.
[Read: <a target="blank" data-add-tracking="true" href="http://www.thestreet.com/story/12023849/1/apples-collapse-a-scholarly-perspective.html"><em> Apple's Collapse: A Scholarly Perspective</em></a>]

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).
1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
SYM TRADE IT LAST %CHG
BSV $80.13 0.00%
AAPL $110.37 -1.75%
FB $88.15 -1.94%
GOOG $606.25 -1.32%
TSLA $245.57 -0.86%

Markets

Chart of I:DJI
DOW 16,374.76 +23.38 0.14%
S&P 500 1,951.13 +2.27 0.12%
NASDAQ 4,733.4970 -16.4820 -0.35%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs