Bond funds have become ticking time bombs as they increasingly move to longer-term debt, writes Fortune senior editor Stephen Gandel.
A growing amount of debt bond funds’ holdings won't mature for a for very long time — on average not until at least 2018, and sometimes much later, Gandel notes. For instance, the Calvert Income bond fund has 5 percent of its holdings in debt that won't be paid back until 2045, and its fourth largest holding is due 2055.
Locking into long-term bonds may be especially dangerous at a time when rates are near record lows and are widely expected to rise. Values of bonds fall when yields rise, and the values of long-term bonds suffer the most.
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Ironically, bond funds have turned to longer bonds for better yields today, since longer terms generally offer higher rates. After all, they market themselves on yields they pay to investors now.
The average duration for long-term bonds increased to nine years from 7 ½ years two years ago, Gandel reports, citing data from Morningstar.
Conventional wisdom holds that short-term bonds are safer if inflation is expected. But not everyone sees it that way.
When rates rose from 2004 to 2006, short-term bonds fell while long-term bonds stayed put, Charles Burge, manager of the Invesco Corporate Bond fund, told Fortune. "People like to hide in the front side of the curve, but it doesn't always work."
Yet it's not clear how much the slide to longer-term holdings is due to calculated investment decisions and how much to a herd-like adherence to bond indexes.
Since funds are compared against indexes, many managers largely match the indexes and make small adjustments to beat them. Yet durations of indexes have gotten longer as more companies opt for long-term loans in an effort to lock in low rates.
Many experts warn that the Federal Reserve's massive Treasury purchases will ultimately ignite inflation.
"The future price tag of printing 6 trillion dollars’ worth of checks," writes Pimco manager Bill Gross in his monthly Investment Outlook commentary "comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold."
That's why investors should avoid long-term bonds and focus on short to intermediate time frames, he says.
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