These Bond Funds' Risks Outweigh Their Potential Rewards

Long-term bond funds and long-term government-bond funds have given up some gains recently, but both categories have posted huge returns for the year to date. Long-term government-bond funds top the fixed-income funds category with a 16.05% return year to date, and long-term bond funds don't trail too far behind with a 13.42% gain.

But investors should temper their enthusiasm for these longer-term bond funds by considering that they have a built-in disadvantage in a rising-interest-rate environment. Bond funds that focus on long-dated securities have higher durations, which make them highly sensitive to interest-rate fluctuations. In a sustained period of rising interest rates, significant capital losses are likely.

Given these risks, investors have more than enough reason to avoid these categories of funds altogether. To help home in on funds that appear to be at a particular disadvantage, we used Morningstar's  Premium Fund Screener to filter within the long-term bond fund and long-term government-bond fund categories. On the fees front, we sought funds with expense ratios above the category average.

We then layered on a screen for less-experienced managers who have helmed the fund for fewer than five years. And to eliminate multiple share classes of the same fund, we required distinct portfolios only and restricted the minimum initial purchase requirement to less than $25,000. Premium members can run the screen by  clicking here.

Below, we highlight two of the screener's results.

 Legg Mason Western Asset Corporate Bond B 
This fund's interest-rate sensitivity is less than is the case for many long-term bond funds; manager Ryan Brist minimizes the fund's interest-rate risk by keeping the fund's duration close to that of its benchmark, the Barclays Capital U.S. Credit Index. But the fund does carry a hefty amount of credit risk. When risk aversion was the prevailing force ruling the market in 2008, the fund lost 23%, while it experienced a 32% gain in 2009's rally when Brist claimed significant positions in bank debt. But despite its impressive gain, the fund's considerable credit risk is impossible to ignore. Add to these caveats the fund's hefty price tag, and it's difficult to make a strong case for this highly volatile fund in any portfolio.

Direxion Monthly 10 Year Note Bull 2X (DXKLX)
This long-term government-bond fund seeks to return twice what its benchmark gains (or loses) in any given month (before fees and expenses). True, the fund has generally benefited from the combination of leverage and a declining interest-rate environment during its lifetime, and its returns land it at or near the top of its peer group during every trailing period. However, taking leveraged positions in long-term Treasuries has led to sky-high volatility and could prove combustible in a sustained period of rising interest rates. For example, in 2008's flight to quality, the fund managed to gain an impressive 45%, but it lost 19% when investors flocked to more credit-sensitive bonds in 2009. This fund's extreme sensitivity to interest-rate changes offsets any potential for investors to reap great reward.