As the negotiations in Washington over raising the debt ceiling heat up, investors are left to ponder what was once unthinkable: Could the U.S. actually default? Such a scenario would almost certainly have a devastating effect on our economy, sending interest rates soaring and the stock market tumbling down. But there's another layer of worry here: Excessive government borrowing has flooded the bond market with Treasury securities. That means investors could be even more heavily exposed to this corner of the market than they realize.
A growing presence
As government debt has swelled to record levels, Treasury bonds now make up a greater proportion of the total bond market. In the benchmark Barclays Capital Aggregate Bond Index, Treasury bonds now account for 33% of total assets, up from less than 24% four years ago. That's quite an increase in the span of just a few years. As a result, some in the industry are worried that bond fund investors are getting overexposed to Treasury debt at just the moment when they should be cutting back. Add to the picture remarkably low yields on Treasury bonds and the likely end of the fixed income bull market, and it's easy to see how investors could get burned.
So should bond investors be fretting about their exposure to Treasury bonds? Well, in general, I think investors should at least be cognizant that bonds of all stripes aren't likely to continue providing the same kind of powerhouse returns that they have in years past. Interest rates are almost certainly headed up in the next year or so, which means bond prices will fall in response. With all the money that flowed out of the stock market and into bonds in recent years, a lot of investors are sitting on an asset class that probably has many of its best days behind it. But whether you should be worried more specifically about your exposure to Treasury bonds depends on where you are in your investing journey.
Time on your side
If you're a youngish investor or simply have more than a decade or so left to go until you retire, bonds shouldn't be a primary focus in your portfolio. You shouldn't shun bonds entirely, but somewhere around a 10% allocation is likely appropriate. So in the context of your total portfolio, Treasury bonds are such a small percentage of your portfolio that you're not really at that much risk. Consider that the iShares Barclays Aggregate Bond ETF (NYSE: AGG ) has a roughly 34% allocation to Treasury bonds, according to Morningstar data. Even if your entire bond allocation is just to this fund, at a 10% allocation, your direct Treasury bond exposure is just 3.4% of your portfolio. That shouldn't sink anyone's portfolio even if Treasuries stumble.
However, if you're still worried about how a potential rout in Treasury bonds could affect your portfolio, check out how your bond funds are invested. Many popular diversified bond ETFs are even more heavily invested in Treasury bonds than the index. For example, Vanguard Total Bond Market ETF (NYSE: BND ) has a 36% allocation to Treasury bonds, while Vanguard Intermediate-Term Bond ETF (NYSE: BIV ) has a whopping 52% exposure to Treasuries. If you're uncomfortable with exposure like this, even if bonds are a small portion of your overall allocation, you may want to think about adding a fund with more of a focus on corporate bonds, or foreign bonds, or both, such as SPDR Barclays Capital International Corporate Bond ETF (NYSE: IBND ) .
Closer to the goal line
Of course, if you're in retirement or close to it, bonds should make up a hefty portion of your portfolio, even at this stage in the bond market cycle. In this case, your Treasury allocation is much more relevant to your overall portfolio. Take stock of your overall portfolio, including individual bonds and bond funds to see how much exposure you have. If Treasuries account for much more than 25% of your total portfolio, you might want to think about doing some diversifying.
In this case, you could consider adding some reasonable-risk bond funds such as the iShares Barclays Intermediate Credit Bond ETF (NYSE: CIU ) , PIMCO Investment Grade Corporate Bond ETF (NYSE: CORP ) , or Vanguard Short-Term Investment Grade Bond Fund (VFSTX). These funds shouldn't make up a huge portion of your bond portfolio, but just enough to bring down your overall Treasury allocation if it's somewhat elevated right now.
While investors shouldn't run away screaming from Treasury bonds, they do need to be aware of the potential risks in this sector right now. While yields remain low, indicating little concern in the market over a potential U.S. default, interest rate risk still abounds. It's never a good idea to be heavily overweighted to any one sector of the stock or bond market, so make sure Treasury bonds are a meaningful, but not outsized, part of your portfolio right now.