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Know How: How Extended Is Your Bond Fund?

Four takeaways from May’s spike in yields.

Kevin McDevitt, 08/27/2013

This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

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 in that month alone. That was the most significant increase in yields since the spikes in late 2010 and early 2011.

What’s surprising, however, is that May’s comparatively mild increase in yields hurt bondfund returns more than the 2010–11 episode did. 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?

1 Durations Are Lengthening
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 partly explains 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.

2 Companies Are Taking
Advantage of the Situation 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 the 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.

3 Your Index Fund May Be at Risk
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.

4 Consider Your Options
It’s not too late to revisit the durations of your clients’ bond funds and perhaps downshift to offerings with shorter durations and lower rate sensitivity. For example, Scout Core Plus Bond’s SCPZX benchmark is the Barclays U.S. Aggregate Bond, 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, down from 4.5 years in January 2012.

A couple of Metropolitan West High Yield Bond’s MWHYX portfolio statistics stand out. Its 3.2-year duration ranks among the high-yield category’s lowest. That reflects the team’s concern about the threat of rising yields, a theme across the firm’s bond-fund lineup. Meanwhile, the portfolio’s overall credit sensitivity isn’t positioned particularly aggressively, relative to most peers.

Osterweis Strategic Income OSTIX survived the latest yield spike even better than expected. With an average effective duration of just 2.0 years, the fund kept its head above water with a 0.08% gain in May even as the yield on the 10-year Treasury shot up 50 basis points. That easily beat the Barclays U.S. Aggregate Bond Index’s 1.8% loss.

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