The Hazards of Bond Index Funds

NEW YORK ( TheStreet) -- Shareholders of Vanguard Total Bond Market Index ( VBTLX) have reason to be disappointed.

In 2012, The Vanguard mutual fund returned 4.2%, compared to 7.0% for the average intermediate-term fund, according to Morningstar.

During the past five years, Vanguard has lagged 60% of its peers. The poor showing is particularly notable because the mutual fund has $120 billion in assets and ranks as the biggest passive bond fund.

Will the index fund continue lagging actively managed competitors? Probably. The problem is that the Vanguard fund has most of its assets in government bonds. Those are likely to lag if the economy keeps growing and interest rates rise.

Vanguard Total Bond Market tracks the Barclays U.S. Aggregate Index, the most popular bond benchmark. Designed to reflect the composition of the investment-grade bond universe, the benchmark has 37% of its assets in Treasuries and 24% in mortgages securities that are backed by the government. Only 21% of assets are in corporate bonds. This is very different from the typical actively managed bond mutual fund, which has a bigger stake in corporate bonds and less in government issues.

During the financial crisis, corporate bonds sank because investors worried about defaults. But after the markets hit bottom, corporate issues rallied hard and enabled actively managed funds to outdo the benchmark.

Corporate bonds no longer sell at bargain prices. But corporates should continue outperforming if the economy grows, as many economists expect.

According to many forecasts, consumers should seek more loans to buy houses and cars. That will push up interest rates. Rising rates hurt bonds of all kinds as investors dump older issues with low yields. But corporate issues tend to do better than the benchmark in periods of rising rates because investors worry less about defaults when the economy is sound.

Investors recently got a taste of how government bonds can fall. During the past month, interest rates on 10-year Treasuries climbed from 1.77% to 1.94%. With prices of government issues falling, the Vanguard index fund lost 0.4%, while the average intermediate fund about broke even.

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