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Why Did My Bond Fund Lag When Treasuries Rallied?

The answers have both short- and long-term implications.

Eric Jacobson, 08/18/2011

Although most of the drama has been in stocks, plenty of fund investors have been watching their bond funds closely during the past few weeks. The equity market's panic was enough to unnerve anyone, and with Morningstar estimates of taxable-bond fund purchases topping more than $630 billion since 2008, the "unnerved" probably includes a lot of us.

But while most can breathe a sigh of relief given that the average high-quality bond fund has enjoyed positive returns, those looking closely may wonder why their core bond funds didn't perform even better. The rally in 10-year Treasury note prices garnered some attention in the news as its yield sank to 2.14% by Aug. 10 even after Standard and Poor's downgraded Uncle Sam from AAA. For the brief run from July 27 to that point, its total return was a generous 7.4%.

So why didn't most bond-fund investors make a killing last week? For one thing, the 10-year Treasury note is a much more interest-rate sensitive--and volatile--individual security than the average core bond fund. Over the past few years, the duration of the 10-year has hovered above eight years (even passing nine at times), as compared with the intermediate-term bond-fund average, which has been around 4.5 years. That lower level of rate sensitivity was a good indicator that the impact of the Treasury rally wouldn't be felt as strongly by the average intermediate bond fund.

Things worked out pretty well for shareholders of Vanguard's Intermediate-Term Bond Index VBIIX and close siblings Vanguard Total Bond Market VBMFX and Vanguard Total Bond Market II VTBIX given their Treasury-bond-heavy portfolios. The former topped the category with a near 4.0% return, while the latter two gained 2.8% and 2.7%, respectively. But, the average intermediate bond fund (up 1.3% from July 27 through Aug. 10) simply couldn't come close to keeping up with the market's bellwether benchmark--the Barclays Capital U.S. Aggregate Bond Index, which returned 2.7%--over that stretch either.

The Wisdom of Crowds?
Why did the average core bond fund find itself at such a disadvantage? The simple answer is that coming into this period, the average intermediate bond fund had a much shorter duration (roughly 4.5 years versus the index's 5.2 years at June 30) and many fewer Treasury bonds, than the index.

The reasons for that leaning reveal quite a bit about the ways in which fund managers are trying to adapt to a post-financial-crisis bond market, the largest boom of bond-fund purchases in the industry's history, and palpable investor fear that rising bond-market yields will eviscerate their portfolios.

PIMCO's Bill Gross was a vocal proponent of the anti-Treasury case early in 2011 but backed away from that thinking as weaker economic indicators began rolling in more frequently. And while he allowed the fund's duration to drift closer to the category average around midyear, he too has continued to run PIMCO Total Return PTTRX and its close siblings with less interest-rate sensitivity--4.6 years of duration at the end of July--than that of the U.S. Aggregate benchmark.

But even though a buildup of roughly 9% in net market value exposure to U.S. government bonds--including both Treasuries and government agency debt--has been at the root of that upward duration shift, it still represents a massive underweighting to the sector relative to the benchmark's weighting. Between Treasuries and government agency bonds--and not including government-backed mortgages--the index boasts a whopping 44% exposure. PIMCO Total Return therefore trailed way behind the index during the July 27 to Aug. 10 stretch, with a gain of 0.39%.

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