Fund investors: Know stake in Treasury bonds

[March 30, 2012]  BOSTON (AP) -- Take a close look at your bond portfolio, and you might be in for an unwelcome surprise. The Federal Reserve's attempt to revive the economy by buying up government debt has left many mutual fund investors with huge stakes in Uncle Sam's IOUs.

Owning more Treasurys is sticking investors with disappointing recent returns, and in some instances losses.

To be sure, Treasurys are super-safe investments that can help minimize losses when stocks decline. So they have a place in any well-diversified portfolio.

Yet yields remain so low that investors with substantial Treasury stakes could suffer modest losses when interest rates eventually creep up from their current super-low levels. With the economic recovery regaining momentum, that risk is growing. When interest rates rise, bond prices decline because investors can get newly issued bonds paying higher interest.

A recent uptick in rates is one reason why the worst-performing mutual fund categories this year are those specializing in government debt. Funds primarily investing in short- and intermediate-term government bonds are earning a paltry 0.2 percent on average this year, while those specializing in long-term government debt have lost 5.5 percent, according to Morningstar.

It's also been a rough year for broadly diversified index funds that passively track the Barclays Capital U.S. Aggregate Bond Index. Most are barely breaking even, returning about 0.3 percent.

The Barclays index, the most widely used bond benchmark, has undergone a makeover in recent years, with Treasurys making up an increasing share of the index. At the end of 2007, just before the financial crisis, Treasurys made up about 22 percent. That's the Treasury weighting that index funds tracking the Barclays Aggregate sought to maintain.

Fast-forward to the end of 2011, and the index's Treasury component jumped to more than 35 percent. Consequently, higher-yielding corporate bonds make up a comparatively smaller piece of the index.

The main reason?

"It's the Treasury market that has been the most manipulated by the Fed," says Warren Pierson, co-manager of the Baird Core Plus Bond Fund (BCOSX).

The Federal Reserve has spent trillions of dollars buying government bonds since the financial crisis, hoping to stimulate the economy and encourage investors to venture into higher-risk investments. The purchases, and the government's increased issuance of Treasurys to keep up with its growing debt, have kept Treasury yields artificially low. They're so low that it's hard to get a decent return unless you accept more risk and invest in stocks or riskier categories of bonds.

Plenty of investors have done that, and stocks have recovered most of their losses since the market peaked in late 2007. Yet Treasurys continue to hold appeal for many nervous investors seeking refuge from stock volatility. That high demand has also kept yields low.

Modest exposure to Treasurys is appropriate, but Pierson says an index approach isn't wise now. It risks leaving bond investors overexposed to investments that he believes are likely to underperform, and possibly suffer losses.

Of course, index funds offer cost advantages over managed funds like the one that Pierson helps run. For example, Vanguard Total Bond Market Index charges an expense ratio of 0.22 percent, compared with 0.55 percent at Baird Core Plus Bond. Those are the ongoing charges for operations, expressed as a percentage of assets.

The Baird fund recently held about 16 percent of its portfolio in Treasurys, about half the Treasury weighting in the Barclays Aggregate index.

That's not unusual. Actively managed bond funds held an average 14.5 percent weighting in Treasurys at latest count, according to Morningstar. Many managers, like Pierson, are discouraged by the meager Treasury yields.

Losses can occur when a fund generates less interest income than going market rates. A fund's returns will vary because the fund manager must continually reinvest as bonds mature. A recent modest rise in Treasury yields means previously issued bonds paying lower interest are worth less than they once were. A fund with too much invested in those older bonds can end up with losses.

While the Fed continues to keep short-term interest rates near zero, pressure to raise them is mounting. Recent economic strength has pushed Treasury yields up slightly higher. For example, newly issued Treasurys maturing in 10 years are yielding around 2.2 percent, up from 1.8 percent a couple months ago.

Of course, Treasurys aren't the only types of bonds that could deliver disappointing returns, or losses, when the Fed eventually raises rates, or if inflation begins to spike. Plenty of other lower-risk, lower-yield bond categories share that vulnerability.

But the Treasury components of many investors' bond portfolios deserve special scrutiny now, and may be in need of some careful trimming. Treasury yields remain historically low, and the Treasury component in the overall bond market has spiked.

The bottom line: Take a look at the latest holdings data for your bond funds, and check how much is invested in Treasurys. If it's substantial, be aware you could be facing losses if the economy continues its recovery. They won't be as painful as the hit you could see from a sharp decline in the stock market. But any loss from a supposedly safe investment like Treasurys is a disappointment.

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Questions? E-mail [e-mail].

[Associated Press; By MARK JEWELL]

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