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Investors need to stay balanced in riskier bond market

Over the past five years, we have heard dire warnings that interest rates would rise and that the bond market—periodically called a bubble—was ready to burst. Hearing the cry of "wolf" so often about rising rates has left many investors too complacent about the very real warning signs that the bond market is getting riskier.

While it's still not known when interest rates will go up and by how much, what we do know is that the bond market is at greater risk to rising interest rates than at any time in recent history.

Risk
Philip and Karen Smith | Getty Images

How do we know this? Three factors at or near their historical highs or lows are contributing to this risk:

1. Duration is the longest in history. Duration is the most common way to measure interest-rate risk. Simply put, the longer the duration, the greater the loss of value when interest rates rise. As a refresher, investment research firm Morningstar has a good definition of duration.

Borrowers, such as corporations, municipalities and the federal government, have taken advantage of the current interest-rate environment to issue bonds at low rates of interest and with longer maturities. By locking in current low rates for a longer period of time, the duration of the bond indices has increased to historic lengths.

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While these lower interest rates are good for borrowers, they're not good for lenders like individual investors. Lower yields and longer maturities present greater risk when interest rates are on the rise.

2. Yields are close to their lowest levels in history. The chart below is a great illustration of the dramatic decline in the yield for the Barclays Aggregate bond index as interest rates have fallen. Currently, this yield is a paltry 2.1 percent. That's not a lot of income cushion to offset any potential decline in the price of your bond portfolio.

Source: Barclays

3. The yield buffer is the lowest in history. In order to understand the impact of longer duration and low yields, let's use a real-life example of one of the largest bond funds today and look back at its history.

According to Morningstar, over the past 30 years, the Vanguard Total Bond fund has experienced six years when the principal loss in the portfolio was more than 2 percent. However, because the income return in each of these years was sizable, no single year resulted in a total return loss greater than 3 percent.

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For instance, in 1987 the rise in interest rates caused the price of the Vanguard Total Bond fund to plummet by a whopping -7.6 percent. Because the income return was so high, at 9.2 percent, the fund still had a total return of 1.5 percent. The income was more than enough to offset the principal loss.

By comparison, the current yield today is a mere 1.8 percent. This, coupled with an effective duration of 5.5, offers the least amount of cushion to offset any rise in interest rates in the fund's history. As an oversimplified explanation of duration, a 1 percent rise in interest rates will cause a 5.5 percent decline to its current principal value.

"Investors may be surprised to find that the sheep in wolf's clothing is more dangerous than they think."

Investors may be surprised to find that the sheep in wolf's clothing is more dangerous than they think. Their traditional bond portfolios could experience more volatility when interest rates rise than other times in history. Not just because interest rates are low but because bond indexes have greater interest-rate risk, coupled with a tiny buffer to help offset losses.

While this may not occur for several more quarters, perhaps it's time to pay attention to those warnings.

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Here's what I suggest investors do. The past two calendar years have offered a pretty clear view of the type of interest-rate risk in bond funds. Look at the loss in 2013 and the gain in 2014. If there was a big swing, consider making a change to shorter-duration funds to mitigate some of your exposure to interest-rate risk.

Many funds companies, including Vanguard and Fidelity, offer short-term bond funds that will likely outperform during a rising interest-rate period. You could also exchange interest-rate risk for credit risk. I like going shorter-term for a lower-quality bond fund. Two examples we use at Glassman Wealth are Osterweis Strategic Income and Nuveen Short Duration High Yield Muni.

—By Barry Glassman, founder and president of Glassman Wealth Services.