Possible Bumps Ahead for Bond Funds?

02/07/2013 8:30 am EST

Focus: BONDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener of the Independent Adviser for Vanguard Investors issues a warning for investors holding bond funds.

While I remain bullish on the long-term case for stocks, I am becoming increasingly concerned about bonds—in particular, bond funds. Even more to the point, my concern is focused primarily on bond index funds that track “total” bond market indexes, like Total Bond Market (VBMFX).

Today, 46% of the Barclays US Aggregate Bond Index is invested in US Treasury and agency securities, which are the highest-quality bonds, but also the most sensitive to changes in interest rates.

In 2009, when investors began their now four-year love affair with bonds and bond funds, only 38% of the Barclays index was allocated to Treasury and agency bonds. In addition, in 2009, the average yield-to-maturity on the index was 4%, while today the yield is closer to 1.7%.

Total Bond Market’s 12-month yield at the end of 2012 was just 2.6%. Four years ago, it was 4.7%. Investors are currently taking on greater and greater interest-rate risk, while at the same time being paid less.

The clock on the bull market in bonds is ticking, and while it may not end with a bang, I think many bond index fund investors are unaware of the dangers that lurk within their seemingly well-diversified and manager-risk free portfolios.

So what could a bond bear market look like? Unfortunately, history provides few clues because we’ve never seen interest rates this low before.

The worst single calendar year bond market investors have experienced in more than three decades was 1994, when the total return was a loss of 2.8%, as the Federal Reserve began a year-long process which raised the Fed Funds rate from 3% to 6%.

While I don’t expect anywhere near the full 3% rise in rates we saw in 1994 and 1995, it’s important to remember that the ten-year Treasury yield was almost 5.9% at the time. Interest payments were capable of making up for a good portion of the price declines that occurred as the Fed hiked rates. Today, the 1.76% yield on Treasury bonds would have a much lesser ameliorating impact.

For instance, if the Fed were to raise rates by just 50 basis points, a ten-year Treasury yielding 1.7% would show a total loss of -2.25%. A full 1% rate hike would see that bond lose 6.19% over the next year. And while it’s probably outside the realm of the possible right now, a hike in interest rates of 1.5% would generate a 10% loss for the ten-year bond.

That’s a reality that I would wager many bond investors are unaware of.

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