The True Risk of Bond ETFs

In coming up with ways to protect their portfolios, many investors draw on lessons learned from their most recent mistakes. Unfortunately, most people right now are taking the lessons they learned from the 2008 bear market and buying bonds, which could easily prove to be far riskier than they thought.

The classic seesaw
With occasional exceptions, the historical relationship between stocks and bonds has largely held true for decades, and it's still true today. Typically, stock prices and bond prices move in opposite directions, as investors alternate trading the prospects of greater returns from riskier assets against the desire for safety and capital preservation. That relationship actually works well for those who maintain a diversified portfolio, as it ensures that even when one type of asset is doing the poorly, the other usually does fairly well to offset some of the losses.

But with so much money moving into the bond market, rates on even the longest-term bonds have fallen to historically low levels. That has created some impressive gains for those who got into bonds early on, but has also increased the risk for those who continue to hold bonds.

Understanding duration
When bond rates are low, the biggest risk is interest rate risk. The key to rate risk is figuring out how much the price of an individual bond or bond fund will drop for every percentage point that overall rates rise.

You can find a simple answer to this question by looking at the duration of the bond or fund in question. In simple terms, duration measures how quickly bondholders get their money back, considering both interest payments and the principal payment you receive at maturity. One simple rule of thumb is that for every year of duration, the bond or fund will lose one percentage point of value for every percentage point increase in rates. So while a fund with a duration of one year would suffer only a 1% loss if rates rise by a percentage point, a fund with a duration of 10 years could lose 10% of its value.

With that in mind, let's look at some of the duration figures for the most popular bond exchange-traded funds:

Source: Morningstar, author calculations.
Breakeven point refers to length of interest payments needed to offset losses from a one-percentage-point rise in interest rates.
* Includes gain from inflation adjustment.

To put this in perspective, keep in mind that interest rates have fallen over a percentage point in just the past few months. Investors have based that precipitous drop largely on the prospects for a severe double-dip recession and fears of a long period of stagnation similar to what Japan has suffered through since 1990.

What that indicates is that if the worst-case scenario doesn't happen, interest rates could rebound very quickly if the economy starts firing again. The speed with which those rate rises could create losses similar to what Treasuries saw in 2009, when the stock market rally encouraged investors to take money out of bonds. And the resulting losses could take years for you to recover through receiving interest payments -- especially since most bond ETFs aren't paying you much of a yield right now.

Know the risk
None of this is to say that you shouldn't have any of your money in bonds right now. Sticking to a reasonable asset allocation strategy makes sense in any market environment. But before you boost your bond exposure beyond its normal levels, make sure you understand exactly how much money you could lose if you make the wrong call.

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Fool contributor Dan Caplinger is appalled at what passes for interest rates these days. He owns shares of iShares Barclays TIPS Bond. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy's word is its bond.