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May 2009 Mutual Fund Red Flags

 Watch out for interest-rate risk.

Greg Carlson, 05/12/2009

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

In the face of a deep recession and a sharp plunge in stock prices, investors have flocked to high-quality bonds, particularly those backed by the U.S. government. As a result, the prices of Treasuries have risen, and their yields have dropped to historically low levels. For example, a U.S. Treasury note maturing in five years paid a yield of just 1.67% at the end of March 2009, and a 10-year note paid 2.71%--less than the long-term rate of inflation. Even if one goes out to 20 or 30 years on the yield curve, the payouts are well below 4%.

The worry here is that low rates make for high interest-rate risk, especially for long-term bonds, which tend to experience much greater price volatility when interest rates fluctuate. Treasuries are priced as if inflation will never return; yet, world governments are printing money like crazy. Should interest rates rise, the meager yields on long-term Treasuries will provide little protection from sizable principal losses. Given these concerns, we think investors should be wary of bond funds that currently sport a relatively high duration (a measure of interest-rate sensitivity). You can find a bond fund's duration on Pages 43 and 45. Below are several funds we think bear watching.

Vanguard Long-Term U.S. Treasury VUSTX
This is a well-run fund with low fees. (Its expense ratio is 0.25%.) David Glocke takes a little less interestrate risk than his typical long-term government-bond fund rival--but that's still a lot of risk. Its duration is 11.8 years, which means that if interest rates rise 1%, the fund would decline roughly 11.8%. True, that sensitivity cuts both ways--in 2008, the fund posted a remarkable 23% gain. And interest rates could stay put for an extended period, or they could even drop. But the downside risk appears quite pronounced here right now. It has certainly manifested itself at times in the past: The fund lost 7% when rates spiked in 1994, and 9% in 1999 when investors fled bonds for equities. This time around it could lose that much or more; the fund has already dropped more than 7% this year, as Treasury yields have risen from their December 2008 lows.

T. Rowe Price U.S. Treasury Long-Term PRULX
This fund sports the exact same duration as the Vanguard fund (11.8 years). And it also delivered a huge 23% gain in 2008 as rates dropped. But manager Brian Brennan exercises a little more flexibility than his counterpart at Vanguard, who sticks almost exclusively to Treasury bonds. Brennan can invest as much as 15% of the fund's assets in governmentguaranteed bonds other than Treasuries, such as Treasury Inflation-Protected Securities and Ginnie Mae bonds, and often comes close to that limit. Over the past year, for example, he has twice moved into TIPS when they were at what proved to be depressed prices, boosting the fund's returns a bit. That flexibility could help the fund if rates spike and Brennan is invested in relatively less-rate-sensitive fare. But we don't want to overstate the potential for that--the fund is still likely to suffer greatly in such a scenario. It lost 6% in 1994 and 9% in 1999.

Vanguard Long-Term Investment-Grade VWESX
This is a far different animal than the other two funds. It focuses on corporate debt--indeed, the fund's name used to include "Corporate" until management desired more flexibility. Because corporate bonds tend to be less sensitive to interest-rate movements, we wouldn't expect this fund to be hammered like the two funds above if rates rise, even though its duration was recently a lofty 11.1 years. Nevertheless, the fund's duration was recently one of the highest in the long-term bond category, as it historically has been. When rates sank in 2002, this fund thrived. (The fund has a different manager these days, but the strategy is unchanged.) Although the historically wide gap between Treasury- and corporate-bond yields could provide some cushion, we'd still expect the fund to suffer if rates rise. It lost 5% in 1994 and 6% in 1999.

Greg Carlson is a mutual fund analyst with Morningstar.

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