Now that the Fed is expected to gradually increase rates, perhaps as early as December, investors should check the average duration in their bond funds to make sure they are comfortable with the level of interest-rate risk they are taking.
"Many investors could be sitting on a ticking time bomb," said Ashish Shah, chief investment officer of global credit and head of fixed income for AllianceBernstein. "They won't likely realize much more price appreciation, but they continue to have very long duration."
This is especially true for investors in bond index funds where the average duration, or sensitivity to interest rate change as measured in years, is higher than for actively managed bond funds.
Globally, bond index funds have an average duration of 7.5 years and an average yield of 1.8 percent whereas actively managed bond funds have an average duration of 5.8 years and an average yield of 3.3 percent, according to Shah's research.
"If rates were to rise by 1 percentage point, these passive funds could lose as much as 7.5 percent," Shah said.
However, credit quality and yield in a bond fund, whether it is active or passive, could cushion the blow from having longer duration bonds in a portfolio.
There is a smaller gap in the average duration and yields for U.S. active and passive bond funds than global funds.
The average U.S. intermediate-term bond fund has a duration of 5.4 years and a yield of 2.2 percent while the average actively managed U.S. intermediate-term bond fund has a duration of 4.9 years and a yield of 2.5 percent, according to investment research firm Morningstar.
A similar trend exists for municipal bond funds, which offer investors federal and state tax advantages. The average muni bond fund has a duration of 5 years and a yield of 2.74 percent whereas iShares National Muni Bond ETF, the largest municipal bond exchange-traded fund, has a duration of 4.75 years and a 2.25 percent yield.
Compare the duration of the largest actively managed and passive U.S. intermediate-bond funds by assets under management in the tables below to see the trade-off between duration and return.