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Beware of Rate Risk in Passive Core Bond Funds

Passive core bond funds have some advantages, but don’t expect protection when interest rates rise.

This article is part of Morningstar's Guide to Passive Investing special report.

Passive funds in the intermediate-term bond Morningstar Category come with a built-in safety net of low fees, typically clocking in at about 10 basis points, compared with a broad Morningstar Category median of 68 basis points. They also carry less credit risk than their typical competitors, making them reliable diversifiers during periods of credit stress.

However, they’re far from risk-free. Heavier-than-average exposure to Treasuries and agency debt makes them vulnerable to losses in interest-rate-driven sell-offs.  Vanguard Total Bond Market Index (VBMFX), for example, which tracks the Bloomberg Barclays U.S. Aggregate Bond Index, had a 42% stake in Treasuries and U.S. agency debt recently, which is 10 or 20 percentage points higher than most active funds carry.

Passive funds also tend to have longer durations than the typical active fund. As of Oct. 31, 2017, for example, duration on the Vanguard Total Bond Market Index was on par with the 6.1 years of the Aggregate Bond Index. That longer duration makes the fund, and other passive options, more vulnerable to rate sell-offs compared with the typical active fund, which sported a duration of 5.5 years.

The table below reflects performance during prolonged interest-rate sell-offs for all active funds in the category, the Vanguard Total Bond Market Index fund, and the U.S. Aggregate Bond Index benchmark.

The Vanguard fund fared just a bit worse than the index in all three periods since 2010, partly reflecting its fees. And it did hold up better (24 basis points) than the active group median in 2013’s taper tantrum. That is partly because of some active funds’ inclusion of emerging-markets' local- and hard-currency debt, which slid by about as much as 30-year Treasuries during that period. However, during the rate shocks of late 2010 and 2016, the Vanguard fund lost quite a bit more than the typical active fund (79 and 105 basis points, respectively) due to large slugs of long-dated Treasuries and a lack of exposure to junk bonds, which posted strong gains in both periods.

Many of our favorites in the category take even less rate risk.  Loomis Sayles Investment Grade Bond’s (LSIIX) 3.2-year duration as of October 2017 reflects the team’s long-standing preference for taking credit risk rather than interest-rate risk in the current low-yield environment. Similarly, the team behind  Dodge & Cox Income (DODIX) has a long-standing underweighting to duration (4.2 years recently) citing the poor risk/reward profile of long-term Treasuries in particular. Instead the team has preferred to take some credit risk, although it has trimmed its allocation to its corporates stake considerably, citing tight valuations. Meanwhile, the team at  Metropolitan West Total Return (MWTRX) has purposefully kept the fund’s duration between six and 12 months short of the U.S. Aggregate Bond Index’s duration since late 2013. The team is concerned about the massive levels of federal debt and liquidity in the system and the potential impacts on inflation and rates.

Such positioning (less rate risk, more credit risk) should help these and many other active funds outpace passive funds in future rate sell-offs. And over the longer term, the active funds’ ability to take on more credit risk has led to bigger gains, albeit with more credit risk. Over the trailing five and 10 years through October 2017, the typical active fund outpaced the Vanguard fund by 30-45 basis points annualized. 

Karin Anderson has a position in the following securities mentioned above: DODIX. Find out about Morningstar’s editorial policies.