The ticking time bomb in bond funds

January 14, 2013, 3:00 PM UTC

Update: 1/16/13, 3:00 PM

FORTUNE — Wall Street is in the process of turning one of its most plain vanilla investments – and one that average investors have flocked to in recent years because of its perceived safety – into ticking time bombs. Unfortunately, no one should be all that surprised. Wall Street does this all the time.

The latest victim of Wall Street’s reverse alchemy: Bond funds. In the past year or so, managers of these funds have been loading up on debt that on average won’t be paid back until at least 2018, and in some cases much, much later.

The largest holding of the Calvert Income bond fund (CFICX), for instance, is debt dated 2047. That investment now makes up nearly 3% of the fund, and is its biggest holding. Also among the fund’s top holdings is a railroad bond that doesn’t come due until 2055. Mathew Duch, portfolio manager of the Calvert Income bond fund, says both bonds have unusual structures that make them less interest rate sensitive than other long-term bonds. Duch, through a spokesperson, says he “shares the risk concern in owning interest rate sensitive bonds in this environment but does not want to give up yield.”

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This seems to be a particularly perilous time to be buying debt tied to the second half of this century. The yield on the 10-year Treasury bond has risen to a recent 1.9%, from 1.6% a month ago. Many market gurus say that this may finally be the year that interest rates, which have been at historic lows, march up.

That’s bad news for all bond investors. But it could be a potential disaster for anyone invested in a fund that’s betting on longer-term debt. Bond prices move in the opposite direction of rates. And the further a bond is from when it’s due to be paid back, the more it’ll lose when interest rates rise.

Based on that you would expect bond fund managers to be shifting into short-term debt. But that’s not what’s happening. According to fund tracker Morningstar, the average duration of intermediate bond funds is four and a half years, which is up slightly from two years ago. For long-term bond funds it’s nine years, up from just over seven and a half two years ago.

“We are at an all-time high in terms of duration risk,” says Rick Reider, who is the chief investment officer of fundamental fixed income at BlackRock. “Even a drift higher in interest rates could be painful for investors with the duration of bond funds where it is today.”

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The general rule of thumb is that for every 1 percentage point increase in rates, a bond will lose the equivalent of its duration in price. So a 5-year bond would lose 5%. For a bond that comes due in 2055, it’s more like 40%. But that’s just the rule of thumb. The real concern, though, is that when investors in what they thought were risk-free bond funds see 10% losses, or more, they may stampede for the exits, creating even bigger losses.

The main reason bond fund managers are plunging into potentially more dangerous debt is low-interest rates. The longer a bond, the more interest it pays. Many bond funds market themselves on yield.

But some fund managers say their long-term bets may not be as risky as it seems. Charles Burge, who manages the Invesco Corporate Bond fund (ACCBX), which has a current duration of nearly seven and a half years, says the widely held belief that short-term bonds are safer is a fallacy. He said the last time rates rose from 2004 to 2006, short-term bonds fell, but long-term yields, and bond prices stayed put.

“People like to hide in the front side of the curve,” says Burge. “But it doesn’t always work.”

And that may end up being true. But the problem is that at least some, and perhaps a good deal, of bond funds’ drift into longer bonds isn’t been driven by any real investing logic. It’s happening on autopilot – another example of how the fund industry is out of whack.

Like with all mutual funds, bond funds are typically measured against an index. As a result, many managers often build portfolios that are similar to the index they are measured against, making small tweaks that they hope will put them ahead.

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And that’s what appears to be winding up the bond fund time bomb. Companies are borrowing money for longer, to lock in today’s low borrowing rates for as long as possible. As a result, the duration of bond fund indexes, which blindly track all the bonds in a particular category, are lengthening as well. The average bond in the widely tracked Barclay’s U.S. aggregate index has a life of a little over 5 years.

Still, there are a number of bond funds sold by well-known companies that have gone even further out on the bond time line. The bonds in Oppenheimerfunds’ Rochester Municipals fund (RMUNX), which invests in New York muni-bonds and has over $8 billion in assets, average eight years. The Fidelity Corporate Bond fund (FCBFX), which has $800 million in assets, has a current duration of just over seven years. The slightly smaller T. Rowe Price Corporate Income fund (PRPIX) is averaging seven. All of those funds are down this year as rates have started to move up.

“Over the long-haul we have found that going for the bonds with the highest yields has always paid off,” Scott Cottier, who manages the Rochester Municipals fund.

And over the past few decades of falling yields that has certainly been the case. The question is whether that has masked a big risk in bond funds, and one that has been growing.

Update: An earlier version of this story said that the Calvert Income’s largest holding was a bond that was due in 2045, and that it was adding to that investment. That was based on the latest available data from Morningstar. In fact, the fund no longer owns that investment. Also, the story was updated to include a comment from Calvert. Calvert did not initially return’s calls for comment.