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A Time to Take Stock in Your Bonds

It's a good time to make sure your allocation to bonds still matches your goals and risk profile.

Eric Jacobson, 02/21/2012

Bond funds are rarely the topic of choice at the proverbial cocktail party, but they've been wildly popular with investors in recent years.

Inflows into taxable and municipal bonds totaled a staggering $870 billion over the past five years, according to Morningstar estimates. Of all the mutual fund categories that Morningstar tracks, meanwhile, none has seen greater growth in assets over the past five years than that of the intermediate-term bond-fund category, which drew in $304 billion in net flows since the end of 2006, more than doubling in size.

Some smaller bond categories grew at an even faster rate. The short-term bond category has grown more than 150% since 2006, for example, while the world-bond category--easily dominated by Templeton Global Bond TPINX, which comprises more than a third of its assets--has more than doubled in size over the period.

For investors who were simply looking to take some volatility out of their portfolios rather than hoping to outperform equities, the shift has worked out well. Most bond portfolios enjoyed a strong rebound as liquidity returned to markets that had been starved of it in 2008, and those with more interest-rate sensitivity picked up additional returns during 2011 as U.S. Treasury bonds rallied, particularly over the summer. The years since 2008's crisis have also proved profitable for most bond funds, although the average large-blend fund still maintains a strong lead with a 18% average annual gain for the past three years through Jan. 31 versus around 9.5% for the average intermediate-term bond fund.

There's Risk in Them There Hills
While some of the shift can certainly be chalked up to demographic trends, growth among bond funds has been white hot. For many investors, bonds now comprise a much bigger slice of their portfolios, potentially leaving them more exposed to risks that had not otherwise been expecting. Front and center among these risks is the perennial concern that rising interest rates could drive bond prices lower. Right now, for example, there's strong reason to believe that short-term bond yields will stay low for an extended period because the Federal Reserve has signaled its intent to keep short-term rates there until late 2014. But while that may "anchor" the market level of short- and intermediate-term bond yields (as PIMCO has described their expectations), that still leaves pitfalls. Even if you buy and hold short-term bonds to maturity, even moderate levels of inflation are likely to produce so-called negative real returns. In other words, you'll get your money back, but the amount of income you'll earn on today's short-term bonds probably won't be enough to compensate for the loss in purchasing power that inflation will cause.

Meanwhile, the Fed's messages don't tell us much about what may happen among longer-maturity bonds. Of late, economic growth has been tepid enough to avoid any widespread panics about inflation that might spook the bond market, but those with exposure to the longest maturities have already felt a taste of what just a little good news can bring. The yield on the 30-year bellwether Treasury bond has bounced around over the past few months, touching a low of 2.76% in October, but overall has seen its yield go to 3.12% as of Feb. 10, 2012, on the heels of more positive news about the economy. On a total return basis, the long bond has shed more than 4% since the beginning of the year.

Most of the core bond portfolios that typically populate the intermediate-term bond category don't take on as much interest-rate risk as the 30-year Treasury, but as of the end of January, their durations recently averaged almost 4.9 years--up from four years in February of 2009--which is now just about in line with the commonly followed Barclays Aggregate U.S. Bond index. That figure implies that a 100-basis-point rise in market yields (that is, 1 percentage point) would be expected to produce a loss of roughly 4.9%. With 10-year Treasury yields currently hovering around 2%, it's easy to imagine that kind of pain--or worse--becoming a quick reality.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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