Fixed Income

Falling rates expose duration risk in bond funds

Double-digit returns on bond funds embracing longer durations can turn on a dime if interest rates start climbing.

Falling interest rates across the global fixed-income market have proven to be a boon for certain bond funds that are pushing the limits on interest-rate risk.

For example, by delivering promised longer-duration exposure, both the Pimco Extended Duration Fund (PEDPX) and the Vanguard Extended Duration Treasury Index Fund (VEDIX) are up more than 32% this year.

Virtually all the top-performing taxable bond funds tracked by Morningstar have gotten there by leaning on duration, which is a measure of a bond’s sensitivity to interest rates that can cut both ways in a hurry.

If, for example, a bond has a duration of five years, the price of the bond will climb by about 5% if its yield drops by one percentage point.

On the flip side, the price of the same bond will fall by about 5% if its yield climbs by a percentage point.

Even though the low-rate cycle is not expected to reverse anytime soon, bond analysts warn against jumping headlong into many of the hottest performers based purely on this year’s returns.

“These kinds of max-duration bond funds are an arrow in the quiver, but you have to ask yourself if you want that in your quiver all the time,” said RJ Gallo, head of the duration committee at Federated Investors.

“They are not meant to be a core bond holding,” Mr. Gallo said. “It depends on what your interest-rate outlook is, but if you’re looking for ballast to reduce portfolio volatility, these funds are not it.”

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, echoed the sentiment that investors and advisers should be careful about chasing the performance of funds that have pushed the limits on their duration exposure.

“Advisers don’t usually look to the fixed-income sleeve for double-digit returns,” Mr. Rosenbluth said. “We are encouraging our clients to be careful with chasing the strong performers because there’s significant risk if the Fed doesn’t continue to cut rates and if bond yields move higher, because rising rates will see the gains erased. And unless bond yields go negative, there’s only so much more gains to be had in these funds.”

Ben Caron, senior managing director and portfolio manager at Newfleet Asset Management, said that even though it is logical that longer-duration bond funds would be performing well in the current environment, he is not a fan.

“We don’t make duration bets,” he said, adding that with $15 trillion worth of negative-yielding bonds globally, the risk of a sudden rate spike is small.

“We think the 10-year Treasury will be range-bound for at least the next 10 months,” Mr. Caron said. “But there’s some risk that rates could move higher from here, and if you’re taking on longer duration exposure that could hurt.”

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As an example of how bond duration can cut both ways, both the top-performing Pimco and Vanguard funds cited earlier declined by more than 20% during the rising-rate cycle in 2013, which was followed by gains of more than 45% by each fund in 2014.

That is not the kind of ride most advisers want to inflict on their clients, especially on the fixed-income side of the portfolio.

“We’re not doing that because it’s a dangerous strategy long term,” said Bill Zox, chief investment officer of fixed income at Diamond Hill Capital Management.

“That’s equity-like volatility, and it goes both ways,” Mr. Zox said. “It is important to be as defensive as you can be in credit and in rate risk without investing in overvalued securities.”