Non-core bonds can be prudent and profitable--but they are not for the unwary.
Core and Explore
Pundits have warned for the several years about "the bond bubble." When all those dollars that have poured into bonds head for the exits, the doomsayers state, fixed-income prices will collapse. The usual pressure that is exerted on securities prices by sales orders will be exacerbated by today's minuscule yields, which means that bonds will lose their value in a hurry as interest rates rise. In addition, the market structure has been damaged, due to the decimation of bond dealers during the 2008 financial crisis.
That may be--or it may not be. Either way, the puncturing of the bond bubble is not this column's topic. Forecasting a marketwide catastrophe is far past my pay grade. Indeed, that task appears to be past anybody's pay grade, judging by how many false warnings have occurred. (One of the most memorable was the havoc predicted from PIMCO Total Return's PTTRX redemptions, in autumn 2014. The bond market would reel when PIMCO closed out its derivatives positions, it was said. Nope. Bond prices rose instead.)
Instead, my concern is the narrower topic of what, for lack of a better term, I call "explore bonds." Core bonds are Treasuries, U.S. government agencies, blue-chip corporate bonds, higher-grade asset-backed securities, and sovereign bonds from developed economies. Explore bonds are what remain. They occupy the market's fringes. They are issues from second- or third-tier companies; or the weaker of asset-backed securities; or nonagency mortgages; or emerging-markets issues. They typically come in small pools, and they are sensitive to economic concerns.
In reality, of course, there are many grades of liquidity for bonds, rather than the two implied by the phrase "core and explore." They range from extremely liquid for on-the-run Treasuries to extremely illiquid for the smallest and most esoteric of issues. The example that follows is particularly dramatic--which is why I chose it. Consider it the case of when the furthest edge of exploration goes wrong.
And they can't withstand sell orders. A vivid recent example is provided by tiny Sandalwood Opportunity SANIX, which managed to lose 9% during the second quarter of 2016, when the average multialternative fund rival gained 1%. (A multialternative fund, by Morningstar's definition, is a fund that invests in various flavors of alternative investments.) Writes management:
The large decrease in the value of the Fund during the second quarter was primarily due to the remaining positions in the energy, metals and mining in our Middle Market Credit sleeve. This continued source of loss in the portfolio was further magnified by investor redemptions which occurred throughout the quarter.
The fund's March 31, 2016 report listed 15% of portfolio assets as belonging to the energy, metals, and mining sectors. If the fund fell almost 10% during the ensuing quarter, with most of that loss occurring from just 15% of the portfolio, well … that's not pretty. The implication is that those securities shed more than half their value. (Not surprisingly, the report continues, "The volatility in the middle market sleeve culminated in the decision to exit the strategy and remove the manager from the portfolio.")
(This picture gives an indication of what can happen when the riskier of explore bonds go awry. Cover the eyes of any minors.)
This tale offers several lessons.
The first is that if you buy an expensive, off-the-beaten-path fund, you are taking your chances. Sandalwood Opportunity had $90 million in assets entering 2016 and a 2.90% expense ratio for its institutional share class. Strange performances tend to occur with minnow funds that have high expense ratios. Their asset bases permit them to invest in small, unusual securities, and their cost handicap motivates them to take chances. Sometime these strange performances turn out to be very good, but more often they do not.
So, if you feel inclined to buy a petite, high-cost fund that holds securities whose names you cannot pronounce, it's probably best to lie on the couch until the urge passes. At the very least, don't say you weren't warned.
Then there's the point that explore bonds can get crushed by sell-offs. Sometimes, they suffer losses that would daunt a small-company stock fund manager. The volatility associated with lower-quality credits, because of their vulnerability to economic shocks, is exacerbated by the bonds' lack of liquidity. We can speculate about how Treasuries might trade during a bond market rout. But we know what happens to explore bonds. If they are already falling in price, and more sellers appear, their quotes disappear--then reappear at much lower levels. The bonds nosedive.
As the Sandalwood case demonstrates, these explosions don't take much kindling. In fact, sometimes they require no fire at all. In second-quarter 2016, when Sandalwood's portfolio burned, high-yield bonds rallied, with the BofA Merrill Lynch High Yield Index gaining almost 6%. The environment was favorable, but the portfolio nonetheless suffered severely. This differentiates explore bonds from core bonds, which nearly always move in the opposite direction of interest rates.
Thus, funds that invest in explore bonds are relatively unpredictable. They are subject not only to the vagaries of their overall marketplace, but also to local effects. In addition, the funds very often participate in their own problems, by causing further losses when dumping securities so as to meet redemptions. Even though Sandalwood Opportunity held less than $100 million in assets entering this year, it damaged its securities' prices by placing sell orders. Some of those positions were less than $1 million.
In short, as a shareholder, you aren't protected from losses from funds that possess explore bonds by guessing the market's direction. You can be right on the economy and wrong on the fund. Nor are you protected by owning smaller funds, which in theory face fewer problems when forced to liquidate their portfolios. As we have seen, it doesn't take much money at all to cause major damage to the bond market's tertiary issues. Bonds are generally thought of as safer and more reliable than stocks, but that is not necessarily so when it comes to trading.
Explore bonds are widely held by funds in the high-yield, multisector, corporate, long-term, intermediate-term, and short-term bond categories. In addition, allocation funds often partake. (As, of course, do some multialternative funds.) Now, I do not wish to overstate the issue: The vast majority of these funds' explore bonds are safer than the issues that troubled Sandalwood. But I do wish to point out that these problems sometimes occur, and that it's difficult as a shareholder to distinguish between those funds that toe the explore line and those that cross it.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.