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.)