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The Intermediate-Term Bond Category Is a Big Tent

Know what to expect from your intermediate-term bond fund.

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As the third-largest U.S. fund category, the intermediate-term bond Morningstar Category sprawls across more than 300 funds and counts $1.4 trillion in assets. The size of the group reflects the essential role that intermediate-term bond funds often play in investor portfolios. Funds in this category invest primarily in investment-grade bonds and keep their durations--a measure of interest-rate sensitivity--in the intermediate-term range. They offer a moderate dose of interest-rate risk and should hold up reasonably well when equity markets suffer losses driven by other factors.

That said, this group is diverse. Some funds in the category hew closely to the investment-grade-only Bloomberg Barclays U.S. Aggregate Bond Index. They often hold large stakes in U.S. Treasuries and agency mortgages as well as investment-grade corporates. Other more adventurous funds take on an extra helping of credit risk, investing meaningfully in junk bonds and/or leveraged bank loans. Some of these funds also venture abroad to buy the debt of developed- and developing-markets countries or companies that issue in these markets; a subset adds exposure to non-U.S. currencies to the mix. Meanwhile, a smaller subgroup invests the bulk of its assets in mortgage-backed and other securitized debt, sectors that include government-backed agency fare as well as private-label debt that can expose investors to losses if borrowers don't pay their loans on time.

This diversity has clear implications for performance. Investors got a taste of these differences in 2018, a year that saw a sharp rise in Treasury yields that almost entirely reversed in the closing two months of the year, big losses for emerging markets, especially local-currency debt, and late-fall weakness in the high-yield market.

The first nine months of the year provided a clear illustration of the interest-rate risk in the category. Most intermediate-term bond funds suffered losses as 10-year U.S. Treasury yields surged. But funds that tend to run with relatively long durations lost the most.  Vanguard Intermediate-Term Bond Index (VBILX), a fund whose 6.3-year duration as of November 2018 made it one of the longest and most interest-rate-sensitive funds in the group, fell 2.1% between January and September, for example. Others suffered thanks to long durations and exposure to emerging-markets debt, which can also run into trouble when U.S. rates rise. Those exposures helped drive  Western Asset Core Plus Bond (WACPX) to a 2.3% loss during the first three quarters of the year. Meanwhile, funds that took on comparatively less interest-rate risk, including  Loomis Sayles Investment Grade Bond (LSIIX) and  DoubleLine Total Return Bond (DBLTX), did noticeably better.

When broader market volatility spiked late in the year, that trend reversed and credit risk dominated the headlines. Junk bonds, which had held up reasonably well earlier in the year, struggled, while long-term high-quality bond yields fell sharply, boosting more rate-sensitive funds. Credit-heavy Loomis Sayles Investment Grade Bond fell 0.6% in the last three months of the year, for example. Meanwhile, high-quality and rate-sensitive funds such as Vanguard Intermediate-Term Bond Index benefited; the fund rose 2% during the year's fourth quarter. Mortgage-heavy portfolios also held up well, with solid gains for  TCW Total Return Bond (TGLMX) and  Fidelity Mortgage Securities (FMSFX).

Investors should never read too much into short-term performance. However, 2018's differing markets provided a reminder of the role that different types of intermediate-term bond funds can play in a portfolio. Higher-quality and more-rate-sensitive bonds can suffer sharp losses when high-quality bond yields rise, but they have historically provided valuable diversification in rockier equity markets, especially for investors with stock-heavy portfolios. Meanwhile, funds with broader investment horizons can offer healthy income streams and good total-return potential but can stumble when markets turn stormy.

Sarah Bush does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.