Duration and credit quality only tell part of the story.
Bond yields have never been lower, but investors continue to flock to bond funds. The taxable-bond group gained more than $260 million in new assets in 2012, according to Morningstar asset flows data, and that was on top of $50 billion in new inflows in 2011. Municipal-bond funds gathered an additional $50 billion in new assets last year. But are bond investors courting more risk than they realize? Yields will eventually go up, and when they do, bond prices might suffer. Investors should understand the risks that lurk in their fixed-income portfolios. Here’s how.
1 Check Your Duration…
Duration is an estimate of how much interest-rate sensitivity bond funds have to changes of market yields. For example, if a fund’s duration is 2.5 years, simply multiple that number by 100 basis points, or 1%. A fund with a duration of 2.5 years should expect to lose 2.5% if interest rates move up one full percentage point. The higher the duration, the more sensitive the portfolio is to moves of interest rates. This comes with a few caveats. It’s not a foolproof number. It is a mathematical construct and cannot possibly account for changes in interest rates in every rate scenario. But overall, it is a pretty good estimate of what investors can expect from a short shock to interest rates in one direction or the other. Duration also works better in some bond categories than others. Duration in traditional fixed-income categories, such as government bonds, works best. It’s less reliable in categories such as multi-sector and high-yield bond. Therefore, a high-yield fund with a duration that floats between three and six years isn’t going to be as rate-sensitive as a three- to six-year high-quality, core bond fund.
2 …Then, Your Credit Quality
A fund’s average credit quality is a weighted average based on the default probability of corporate bonds. But don’t put too much emphasis on this figure. Because the default probabilities of junk bonds have been so high over the recent decades, numbers are skewed. The average credit-quality of any portfolio holding junk bonds is going to be low. Just as important is the breakdown of the fund’s credit strata, AAA on down to high yield. Credit quality is a good place to look to determine how risky a bond fund is.
3 Keep an Eye on Sector Weightings
Where a fund is putting money might say more about risk than its credit quality. For example, a lot of emerging-markets debt is relatively high-rated because many of these countries have improved their fiscal health. But emerging-markets debt tends to volatile in the marketplace. So, even though things might look okay on the credit side, a large weighting of emerging-markets bonds could mean trouble in a big sell-off.
4 Don’t Get Too High on Yield
Investors will usually be able to see the roots of risks by paying attention to duration, credit quality, and sector weightings. But if you’re still uncertain, look at yield. If it’s significantly higher than the peer group’s, bank on the fact that there is extra risk built into the portfolio somewhere.
5 Shelters From the Storm
Investors who want to shield their portfolios from excessive interest-rate sensitivity should head to the short-term bond category. Below are three options that have a Morningstar Analyst Rating of Gold:
Vanguard Short-Term Bond Index
T. Rowe Price Short-Term Bond