The Increasing Risks of Bond Index Funds

Stan Luxenberg

NEW YORK ( TheStreet) -- Most bond ETFs have sunk lately. This year Vanguard Total Bond Market has dropped 4.6%, while iShares Barclays 20+ year Treasury Bond 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 , 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 , 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 , Frost Total Return Bond , Scout Core Plus Bond and Western Asset Mortgage Backed Securities .

The Western Asset fund ranks as one of the stars of the recent downturn. While most bonds lost money in May, Western Asset gained 1.2% for the month. The fund holds securities that are backed by pools of mortgages, which often yield more than Treasuries and tend to be resilient in downturns. "The mortgage market is one of the few fixed-income sectors where you can get some shelter from higher rates," says portfolio manager Steve Fulton.

While most mortgage securities cannot default because they are backed by government agencies, Western Asset has about a quarter of its assets in non-agency mortgages. Those did not qualify for government backing because the loans were too large or homeowners had weak credit records. While the non-agency mortgages can default, they compensate with richer yields. In May, non-agency securities performed particularly well. With the economy improving, investors figured that the risk of default was lower and bid up prices of shakier mortgages.

Scout Core Plus Bond has the flexibility to range widely, holding emerging markets bonds one year and shifting to Treasuries the next. The fund typically has a duration that ranges from three years to seven years. "The idea of holding static bond positions is not going to work in the kind changing market environment that we face," says portfolio manager Mark Egan.

Earlier this year, Egan worried that interest rates had sunk to unsustainably low levels and were bound to rise. For protection, the fund took a defensive stance, moving away from low-quality bonds and shortening maturities. The caution enabled the fund to outdo peers in May, losing 0.8%. Remaining wary, Egan has a duration of 3.75 years, which should help Scout continue to outperform if rates rise.

Another flexible fund is Frost Total Return Bond. Portfolio manager Jeffery Elswick is free to buy a wide range of securities of different credit qualities. The approach has produced winning results, returning 1.2% this year, while the Barclays Aggregate lost 2.8%. Elswick has scored gains with unloved commercial mortgage-backed securities, which are backed by portfolios of mortgages on office buildings and other properties. He has favored mortgages that were issued in 2005 and 2006, the height of the real estate frenzy. "Those have traded at large discounts because there is a perception that the loans were not sound," he says.

Following an unorthodox strategy, Ave Maria Bond stayed in the black in May. Unable to find bonds with attractive yields, portfolio manager Richard Platte, Jr. had more than 10% of assets in cash. In addition, he held some dividend-paying stocks, which can rise when most bonds fall. Much of the rest of his portfolio was in bonds with relatively short maturities. "We have been very concerned about rising interest rates for some time," he says.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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