It is no secret the U.S. government has borrowed heavily to cover its expenses and prop up the economy. What investors might not realize: This has significantly altered the complexion of the U.S. bond market and, with it, the holdings of mutual funds that hew to bond indexes.
Many mutual funds, especially index funds, are designed to resemble the market as a whole, so the government's decision to borrow trillions has prompted them to buy more and more Treasury bonds. At a time when some investors are questioning whether the long Treasury rally is overheated, this means fund holders face a difficult choice.
"We've had a lot of conversations with investors," says Matt Tucker, head of fixed income at iShares, the popular brand of index-tracking exchange-traded funds. "You have to make a choice whether to increase Treasurys or bet against Treasurys by buying something else."
Total U.S. Treasury debt has ballooned to more than $13.6 trillion in September 2010 from about $9 trillion in September 2007, just prior to the financial crisis, according to the Treasury Department. In the same period, corporate and mortgage borrowings have been sluggish.
This dynamic has altered the face of popular bond indexes, which are typically weighted by the market value of outstanding bonds. For example, Treasury bonds now make up almost 33% of the Barclays Capital U.S. Aggregate Bond Index, up from less than 24% four years ago, and their highest level since the late 1990s.
The jump comes at a time when many bond-market experts, perhaps most notably Pimco's Bill Gross, have been warning that razor-thin yields, currently about 3% on 10-year Treasurys, signal a coming bear market. Gross's Pimco Total Return, the world's largest bond fund, has less than 10% of its holdings in Treasurys and Treasury Inflation-Protected Securities, according to Morningstar Inc.
Pimco didn't respond to requests for comment.
Not everyone shares Gross's concerns. While warnings about Treasury prices have been sounding off for months, so far prices haven't responded. Die-hard indexers tend to believe that, as with stocks, investors do better relying on the wisdom of the market. Their argument: the fact that investors have continued to pay top dollar for Treasurys despite measly yields reflects a market consensus that they are worth it.
"When you start to tweak a bond portfolio, it's tricky to be successful," says Joseph Davis, Vanguard Group's chief economist. "You have to anticipate events."
Still, experts say, investors who own index funds should at least be aware of the risks their funds have been taking. And some are taking action.
Merritt Island, Fla., financial adviser Steve Podnos worries Treasury bonds' extra-thin yields would provide too little cushion against losses if interest rates rise sending bond prices downward. As a result, last month he moved his clients from the Vanguard Short-Term Bond Index Fund to Vanguard Short-Term Investment-Grade Bond Fund--a move that was prompted after he noticed the proportion of Treasurys in the broader-based fund had climbed to nearly 60%.
"We thought we had a nice mix of various kinds of short-term bonds." he says. "We had mostly Treasurys."