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Long Term Bond Funds: High Risk, High Return

How would you like to own a bond fund that managed to return 55.9% in a single year? That’s what the Vanguard Extended Duration Treasury ETF (EDV) did in 2011 – a year that brought a sharp decline in U.S. Treasury yields. Great results, to be sure – but investors need to be acutely aware that long-term bond funds also carry substantial risks.

From the return figures above, it’s clear that long-term bond funds can sometimes provide the type of gains that are typically associated with higher-risk asset classes such as small-cap stocks. The reason for this is that when bond yields fall, longer-term issues generally provide the best performance. As a result, 2011 was the perfect environment for these funds: during the course of the year, the yield on the 10-year note plunged from 3.31% to 1.87% as its price rose. (Keep in mind, prices and yields move in opposite directions .)

Long-term bond funds can therefore be an excellent trading vehicle. but not necessarily the best investment. This is particularly true for bond investors, who are usually looking to collect income and minimize volatility. Unfortunately, these funds have volatility in spades.

Take the one-week period from March 7 – March 14, 2012. During this time, investors sold U.S. Treasuries with reckless abandon in response to mounting evidence of improving economic growth. In this short interval, the fund mentioned above, EDV, returned -7.18%. Most bond investors would consider such a return a bad year. but this meltdown took only a week. Be aware of the downside risks if you’re considering an investment in a long-term bond fund.

Keep in mind, also, that the risk-and-return characteristics of a long-term bond fund will be affected by its underlying holdings. A long-term fund that invests in asset classes with higher credit risk. such as corporate or high yield bonds. may have greater risk than one which focuses on lower-risk market segments.

The Implications of the Broader Rate Cycle for Long Term Bond Funds

Investors who are considering these funds need to think about the broader interest rate cycle. U.S. Treasury yields have been in a downtrend since 1982, and they are being pinned at very low levels by the ultra-low interest rate policy of the U.S. Federal Reserve. Any sign that economic growth is returning to a normal footing and/or that the Fed is preparing to boost rates, will likely send Treasury yields soaring higher — as we witnessed during the second quarter of 2013.

Again, this indicates that these funds — many of which have strong past performance numbers due to the long bull market in bonds — may prove to be a questionable long-term investment if rates rise in the years ahead.

Disclaimer. The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.