Long-term bond funds are a solution that can offer investors extraordinarily high returns in exchange for significant risk. For example, in 2011, a year that had acute declines in U.S. Treasury yields, one fund, the Vanguard Extended Duration Treasury ETF, brought in 55.9% returns to its investors. Along with the possibility of extremely high returns, however, comes significant risk. The following year, during the course of just one week, the same fund returned -7.18%–a number that would, to most investors, be considered a “bad year” for a return. In this case, this dramatic decrease in returns took place over the course of a single week.
Long-term bond funds, because of their potential return rate, can provide the types of returns that are usually linked to high-risk assets types like small-cap stocks. Often, when the returns on bonds fall, longer-term funds perform best. This inverse relationship was exemplified in 2011—as the U.S. Treasury yields plummeted, funds like the Vanguard Extended Duration Treasury Exchange Traded Fund soared.
For this reason, long-term bond funds are not always a wise investment and are often better utilized as a trading vehicle than a long-term investment plan or solution. Bond investors, generally speaking, are often aiming to accrue income with minimal volatility and maximum security. Long-term bond funds, however, are extremely mercurial and can experience dramatic swings in value, often making them a poor fit for traditional minimum-risk-seeking bond investors.
Additionally, investors must keep in mind that, as with any bond fund, a long-term bond fund is dependent on the holdings from which it is comprised. A long-term bond fund with assets that are generally considered to be higher-risk is going to, by extension, be higher risk in and of itself. An example of higher-risk holdings would be high yield bonds or corporate bonds, asset classes which carry a much higher credit risk.
Investors who investigating long-term bond funds as a possible investment solution must also take into consideration a broader interest rate cycle. U.S. Treasury yields have been consistently downward trending for over three decades and are being held in place by very low-interest rate policies of the Federal Reserve. It is easy to forget, when this climate has remained the status quo for so long, that this is subject to change, and that the results of that change would be significant on bond holdings. If economic growth shows a considerable, consistent increase or the Federal Reserve indicates that it is likely to raise rates, yields for the U.S. Treasury will almost certainly skyrocket. If these rates do increase, long-term bond funds will prove to be a volatile and unwise investment due to the inverse relationship of Treasury rates and long-term bond fund returns.
When considering an investment in long-term bond funds, investors must take several factors into account. These include the high degree of risk that these funds carry, particularly when potential changes to the U.S. Treasury and Federal Reserve rates are taken into consideration. Investors also should consider the asset holdings which comprise the bond fund—more volatile holdings will indicate a riskier fund. Finally, investors should, as always, take into account their individual investment goals and consult with an investment advisor if they are unsure.
About Lawrence Meyers
Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]