Take a close look at your bond portfolio, and you might be in for an unwelcome surprise. The Federal Reserve's attempt to revive the economy by buying up government debt has left many mutual fund investors with huge stakes in Uncle Sam's IOUs.
Owning more Treasurys is sticking investors with disappointing recent returns, and in some instances losses.
Treasurys are super-safe investments that can help minimize losses when stocks decline. So they have a place in any well-diversified portfolio.
But yields remain so low that investors with substantial Treasury stakes could suffer modest losses when interest rates eventually creep up from their current super-low levels. With the economic recovery regaining momentum, that risk is growing. When interest rates rise, bond prices decline because investors can get newly issued bonds paying higher interest.
A recent uptick in rates is one reason the worst-performing mutual fund categories this year are those specializing in government debt. Funds primarily investing in short- and intermediate-term government bonds are earning a paltry 0.2 percent on average this year, while those specializing in long-term government debt have lost 5.5 percent, according to Morningstar.
It's also been a rough year for broadly diversified index funds that track the Barclays Capital U.S. Aggregate Bond Index. Most are barely breaking even, returning about 0.3 percent.
The Barclays index, the most widely used bond benchmark, has undergone a makeover in recent years, with Treasurys making up an increasing share of the index. At the end of 2007, just before the financial crisis, Treasurys made up about 22 percent. That's the Treasury weighting that index funds tracking the Barclays Aggregate sought to maintain.
Fast-forward to the end of 2011, and the index's Treasury component jumped to more than 35 percent. Consequently, higher-yielding corporate bonds make up a comparatively smaller piece of the index.
The main reason?
"It's the Treasury market that has been the most manipulated by the Fed," said Warren Pierson, co-manager of the Baird Core Plus Bond Fund (BCOSX).
The Federal Reserve has spent trillions of dollars buying government bonds since the financial crisis, hoping to stimulate the economy and encourage investors to venture into higher-risk investments. The purchases, and the government's increased issuance of Treasurys to keep up with its growing debt, have kept Treasury yields artificially low. They're so low that it's hard to get a decent return unless you accept more risk and invest in stocks or riskier categories of bonds.
Plenty of investors have done that, and stocks have recovered most of their losses since the market peaked in late 2007. Yet Treasurys continue to hold appeal for many nervous investors seeking refuge from stock volatility. That high demand has also kept yields low.
Modest exposure to Treasurys is appropriate, but Pierson said an index approach isn't wise now. It risks leaving bond investors overexposed to investments that he believes are likely to underperform and possibly suffer losses.