Watch Out for Low-Quality Bonds in These Balanced Funds

Low-quality fixed-income securities have had a solid run of late, outperforming higher-rated bonds in the risk-on environments of 2019, 2021, and the first half of 2023, as well as in 2022′s downturn, when soaring interest rates punished rate-sensitive fare. High-yield bond funds on average surpassed intermediate core bond funds by more than 2 percentage points annualized from January 2019 through July 2023. Given this backdrop, let’s take a closer look at allocation funds taking on significant credit risk compared with peers.

Some allocation funds consistently limit their exposure to credit risk while others attempt to juice total returns and/or income with a substantial stake in lower-rated debt. T. Rowe Price Capital Appreciation PRWCX fits in neither category; longtime manager David Giroux and team are more opportunistic, shifting the fund’s fixed-income portfolio based on the team’s views of the bond market. For the past several years, the team has devoted as much as 15% of the fund’s total assets (and roughly half of the bond portfolio) to bank loans, which are typically sub-investment-grade securities. As a result, at the end of March 2023, 60% of the fund’s fixed-income exposure was stashed in below-investment-grade debt—far above the 9% weighting of the average moderate-allocation fund. That credit risk is offset to some degree by the fund’s growing allocation to Treasuries following interest rates’ surge. The fund has typically been more volatile than its average peer in recent years in part because of its fixed-income positioning. But strong security selection has led to consistent outperformance in both up and down markets.

The fixed-income portfolio of Loomis Sayles Global Allocation LGMAX casts a wide net. Like the firm’s fixed-income flagship, Loomis Sayles Bond LSBRX, this fund is willing to hold substantial stakes in both high-yield and emerging-markets debt. Such exposures can differentiate the fund from peers and arguably play to the strengths of the firm’s fixed-income group. But such tilts come with both credit risk and, when emerging-markets exposure is unhedged, currency risk. Indeed, this fund has been more volatile than most of its global allocation Morningstar Category peers over the long term. And while the managers have typically navigated such risks well, as evidenced by the fund’s solid long-term record, a bet on emerging-markets bonds contributed to the A shares’ painful 23.3% loss in 2022, which was worse than nearly all category peers. And high yield actually helped, relatively speaking, during this period.

Oakmark Equity and Income OAKBX has evolved into a vehicle that better balances the risks of its equity and fixed-income portfolios than it did previously, but the fund is still not for the timid. For years, the fund invested heavily in corporate bonds, relying in large part on the firm’s accomplished equity team for its research into individual firms. But in the past several years, the firm has built a dedicated fixed-income team that features four full-time members (including comanager Adam Abbas), and longtime comanager Colin Hudson serves as co-head of fixed income in addition to his equity-related duties. As a result of the additional resources, coupled with changing market conditions, the fund’s fixed-income portfolio looks more diversified than ever before; at the end of March 2023, corporate bonds constituted less than half of that sleeve, with 33% in government bonds and 15% in securitized debt. But investors shouldn’t overlook the credit risk that remains here: 14% of the bond portfolio was invested in high-yield bonds, and another 26% was in BBB rated securities.

This article first appeared in the July 2023 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.