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These 5 Balanced Funds Have Taken on More Credit Risk

Are they ripe for a setback?

Greg Carlson, 09/18/2014

Moderate- and conservative-allocation funds, which respectively stash 50% to 70% and 20% to 50% of their assets in equities and typically invest most of the remainder in bonds, are often designed as core holdings. That mix of stocks and bonds can smooth over the rough patches that each asset class goes through over time. But as my colleague Christine Benz pointed out in a column last week, many of these funds take on significant credit risk, sporting average credit qualities of BB (the first notch below investment grade) or lower. While that profile isn't necessarily a reason to avoid an allocation fund, such positioning can increase a fund's sensitivity to the equity markets: High-yield bonds tend to decline in price when equities fall, so that core allocation holding may provide less cushion in a downturn than expected.

This article focuses on allocation funds that are taking on significantly more credit risk now--nearly six years into a bull market for high-yield bonds--than they did when high yield bottomed out in late 2008 (before equities hit their trough in March 2009) as the financial crisis deepened. Thus, each was late to the high-yield party to varying degrees. We limited the list to moderate- and conservative-allocation funds that hold at least 30% of their assets in bonds, as credit-quality changes will have less of an impact on funds with small bond stakes.

Manning & Napier Pro-Blend Extended Term MNBAXManning & Napier Pro-Blend Moderate Term EXBAXManning & Napier Pro-Blend ConservativeTerm EXDAX 
These three funds are part of a series of four that mix stocks and bonds. (The fourth, Manning & Napier Pro-Blend Maximum Term EXHAX, is an aggressive-allocation fund with a single-digit bond weighting, so it didn't make the cut.) The equity and bond portfolios for each fund are run by a veteran team that shifts the funds' equity/bond splits based on the number of opportunities they find in each asset class.

Late in the previous decade, the funds' fixed-income portfolios sported hefty allocations to Treasuries and other AAA rated government-backed bonds (at least 88% of fixed-income assets at the end of September 2008), thus their average credit quality was AA (one notch below the highest-quality level, AAA). This conservative posture helped the funds weather the rough seas of the crisis better than most peers--each of the three funds lost less than at least three quarters of category peers in 2008. However, the funds posted mixed results in 2009's rebound by equities and high-yield debt. The team then bought more corporate bonds, particularly those rated BBB, as well as a smattering of high-yield bonds. (Much of this move occurred in late 2009 and early 2010.) As a result, each fund's average credit quality was recently BBB. That shift has boosted performance at times but also contributed to subpar results on average in 2011's third-quarter meltdown when macroeconomic concerns caused investors to flee to the perceived safety of Treasuries.

The team usually doesn't make big, sudden changes, as it doesn't make short-term calls. This trait has often served the funds well, but given their current fixed-income positioning, they could be hit if the high-yield market endures a correction in the near future. That said, the managers recently noted that they are working to improve credit quality, and each fund earns a Gold Morningstar Analyst Rating, which indicates our confidence in the funds' long-term prospects.

John Hancock Balanced SVBAX 
This moderate-allocation fund, which typically invests 30% to 40% of its assets in bonds, has also changed its credit-quality profile in recent years. Jeff Given, who has managed its bond portfolio since 2006, made the right call when he stashed more than two thirds of that sleeve in AAA rated bonds (and virtually nothing in high-yield debt) for much of 2008. That's one reason why the fund lost less than roughly three quarters of its peers that year. The fund posted so-so returns in 2009 and 2010 because of this conservative posture as well as an equity portfolio largely focused on stable growers.

However, the fund has since taken on more credit risk, boosting its stakes in corporate bonds on the lower rungs of investment grade (BBB, primarily) and in high yield. The fund subsequently lost more than its typical peer in late-2011's flight to quality but outperformed in the rally of 2012 and 2013. (The fund also landed in the category's top quartile in 2014 through Sept. 16.) All told, its average credit quality has dipped from A in 2008 to a recent BB. Its stake in BBB rated debt has doubled during that span to 28% of the fixed-income portfolio, while high-yield bonds now comprise a quarter of that sleeve. While this increased appetite for risk has been beneficial at times--the fund surpassed 86% of peers during the past three years, though it looked just average over five--it could bite back if investors grow cautious.

USAA Cornerstone Moderate USBSX 
This fund has consistently owned more corporate bonds than the typical moderate-allocation fund. Indeed, this stance contributed to the fund's poor absolute and relative performance in 2008's decline as well as its big gain in 2009's rebound. But the managers have also gradually moved down the credit-quality ladder in recent years. The fund's weighting in BBB rated bonds increased from 29% of the fixed-income portfolio in late 2008 to 41% at the end of July 2014, and its high-yield stake tripled during that span from 6% to 18%. (This shift did not, however, lead to peer-beating performance in the rally of 2012 and 2013, and the fund's returns were subpar over three, five, and 10 years.) The team does appear to be downshifting a bit; its BBB and high-yield stakes were modestly lower in July than they were in November 2013, and its slug of AAA rated bonds has grown from 8% to 18% in that span.



Greg Carlson is a fund analyst with Morningstar.

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