Investors have two ways to seek high returns in the bond market: take on higher credit risk or invest in longer-term bonds. This year, extending credit risk would have worked very well, as evidenced by the outperformance of corporate, high yield, and emerging market bonds. But investors also would have been rewarded by taking on more interest rate risk, as well. Consider the following return relationships year-to-date through December 5:
- The Vanguard Long-Term Corporate Bond ETF (ticker:VCLT) had returned 12.1%, versus 5.6% for Vanguard Short-Term Corporate Bond ETF (VCSH).
- iShares Trust Barclays 20+ Year Treasury Bond Fund (TLT) was ahead 6.0%, versus 2.5% for iShares Barclays 3-7 Year Treasury Bond Fund (IEI).
- The Market Vectors AMT-Free Long Municipal Index ETF (MLN) had delivered a total return of 13.4%, outpacing the 2.1% return of Market Vectors Short Municipal Index ETF (SMB).
If you owned any of these longer-dated funds, congratulations - it's been an outstanding year. But if you're thinking of buying in now, it's essential to look past recent performance and consider what will happen if longer-term Treasury rates reverse their 30-year downtrend and begin to rise. In this scenario, the relative performance of the shorter-term bonds funds would be vastly superior. While there is nothing on the horizon to suggest an immediate jump in long-term rates, those considering long-term bond funds here need to understand that the risks are beginning to outweigh the potential rewards.