Let May's yield spike be a wake-up call on duration.
Bond investors have been hearing for some time that rates will eventually rise, wiping out any meager gains from income. But they haven't had much cause for worry; that is, until rates spiked in May for the first time in nearly three years. The yield on the 10-year Treasury note rose 50 basis points (or 0.5%) in that month alone. That was the most significant increase in yields since late 2010/early 2011. Back then, the rate on the 10-year Treasury rose to 3.75% in February 2011 from 2.41% in early October 2010.
What's surprising, however, is that May's comparatively mild increase in yields hurt bond-fund returns more than the 2010-11 episode. The average intermediate-term bond fund lost 1.3% during the 127-basis-point hike in 2010-11. But during May's 50-basis-point increase, the typical intermediate-term bond offering lost 1.6%. It's also worth noting, though, that the 2010-11 yield spike occurred over a longer period, which allowed investors to accrue more income to offset price declines.
Still, the difference between those two periods is striking. What's going on here? What stands out is that the average effective duration on many bond funds has quietly increased in recent years, making them more rate sensitive than in the past. This could partly explain why this latest hit was worse than the prior sell-off. The typical intermediate-term bond offering had an average effective duration of 4.0 years in early 2009. Four years later, the category's average effective duration has risen to nearly 4.9 years.
Part of this increase in duration owes simply to falling yields. Even with two interest-rate spikes in four years, the current 2.2% yield on the Barclays U.S. Aggregate Bond Index is still lower than the 4.2% recorded in January 2009. Lower yields push cash flows further out into the future, thereby lengthening duration.
But the increase also owes to corporate and government issuers taking advantage of low rates and issuing more long-term paper. This has been a goal of the U.S. Treasury since October 2008, when the average maturity on federal debt was a short 4.0 years. By May 2012, average maturity had risen to 5.3 years. Corporate issuers have similarly jumped at the chance to issue long-term debt at low yields. Indeed, if anything, corporate issuers are being more aggressive. The duration for Vanguard Intermediate-Term Corporate Bond Index ETF VCIT is 6.5 years versus just 5.1 years for sibling Vanguard Intermediate-Term Government Bond Index ETF VGIT. Highly rated Johnson & Johnson JNJ famously issued 30-year bonds in 2010 at a then-record low coupon of 4.50%. Apple AAPL recently trumped that when it sold 30-year bonds at a coupon of just 3.85%.
Added Risk for Index Funds?
What's notable is that this new issuance has generally led to longer durations for index offerings rather than for actively managed funds. That's because active managers don't have to indulge in the long-term paper. As mentioned above, the typical actively managed intermediate-term bond fund has a median duration of 4.9 years. By contrast, the Barclays U.S. Aggregate Bond Index has a current duration of 5.3 years. The reverse was true in early 2009 when the typical intermediate-term bond fund had a 4.0-year duration versus 3.7 years for the index. So while funds tied to such indexes have sometimes seen their durations increase significantly, active managers are generally leery of rising rates and have kept duration more contained.
For like-minded investors, now may be a good time to revisit the durations of their existing bond funds and perhaps downshift to offerings with shorter durations and less rate sensitivity. Below are three funds with especially short durations.
Scout Core Plus Bond SCPZX
The fund's benchmark is the Barclays U.S. Aggregate Bond Index, but the managers don't tether its sector weights or duration too closely to those of the bogy. They purposefully shortened the fund's duration to just 2.0 years as of April 30, 2013, down from 4.5 years in January 2012. For now, they're content to match the yield of the Barclays Aggregate with less interest-rate risk. Beyond the managers' recent concern over interest-rate risk, the fund has traits that make it a worthy long-term holding, starting with a disciplined investment style that balances bold sector calls with circumspect security selection.