The Error-Proof Portfolio: Are Bonds Adding to Your Equity Exposure?

These are trying times for yield-seekers. The Federal Reserve has kept interest rates ultralow for more than two years, and Federal Reserve chairman Ben Bernanke gave no indication in his recent press conference that the Fed will depart from that stance anytime soon.

That may be good news for those in the market for home loans, but it's surely unwelcome for seniors and others trying to wring a livable income stream from their portfolios. Yields on cash instruments such as certificates of deposit are barely in the black, while you're lucky to pick up a yield of more than 3% on an intermediate-term bond fund.

On the Hunt for Yield
Given that unyielding (sorry, couldn't resist) backdrop, it probably shouldn't be surprising that some investors appear to be doing a little good old-fashioned yield-chasing. Among bond funds, some of the biggest beneficiaries of new assets during the past year have been those that offer higher yields than plain-vanilla, high-quality bonds in exchange for some extra risk. High-yield bond funds have picked up an estimated $15 billion in new money during the past year, while bank-loan funds have raked in twice that amount, according to recent Morningstar fund-flow data.

Of course, it's highly possible that investors are making the not unreasonable bet that the economy will continue to improve, thereby boosting these credit-sensitive sectors of the bond market. (Issuers are less likely to default on their bonds in a strengthening economic environment.) But it's also likely that some investors are focusing on the potential for higher yields without paying due attention to the downside.

All market shocks are different, of course, but they're often characterized by a flight to quality that puts pressure on credit-sensitive securities such as high-yield bonds and bank loans. During the period from mid-2007 through December 2008, for example, high-yield bond funds lost 29% cumulatively, on average, while the typical bank-loan fund lost 31% during that same stretch. That sell-off precipitated an unprecedented buying opportunity in credit-sensitive bonds, but following a more than two-year runup in such securities, valuations aren't what they once were.

One rule of thumb for navigating the high-yield market is that you want to be a buyer when the spread--or yield differential--between Treasuries and high-yield is 8 percentage points and a seller when it's 4. (Bond yields move in the inverse direction of their prices, so yields are a good proxy for valuation.) The spread between  SPDR Barclays Capital High Yield ETF (JNK) and  SPDR Barclays Capital Intermediate Term Treasury ETF (ITE) was recently 4.85%.

Faux Diversification
In addition to considering the risks, investors who are venturing into credit-sensitive bonds at this juncture should also be aware of what they might not be getting: diversification, particularly if they're looking to bonds as an antidote to an equity-heavy portfolio.

It's true that credit-sensitive sectors like high yield and bank loans are often considered a good diversifier for portfolios that are skewed toward high-quality fixed-income securities such as government bonds, mortgage-backed securities, and high-quality corporate debt. During the past decade, the typical high-yield fund in Morningstar's database has had a negative correlation with the Barclays Capital Aggregate Bond Index, meaning that the two assets' performance patterns have been substantially different. Ditto for the average bank-loan offering. The (thoroughly addictive) website assetcorrelation.com corroborates those data in this nifty table, showing that high yield is one of the only pockets of the bond market to actually have a negative correlation with other bond-market sectors.

The high-yield sector's performance correlation with the equity market, by contrast, is much stronger. During the past decade, high-yield bonds have a correlation coefficient of 0.70 with the S&P 500, and it's drifted even higher during the past three- and five-year periods--to 0.78 and 0.76, respectively. (A correlation of 1.0 means that two assets are perfectly correlated.) Bank-loan funds haven't been quite as correlated with stocks, with correlation coefficients with the S&P 500 of 0.60, 0.62, and 0.51 during the past three-, five-, and 10-year periods, respectively. Nonetheless, both asset classes are much more highly correlated with the stock market than they are bonds.

What Now?
Does that mean you should reflexively avoid high-yield and bank-loan funds? Not necessarily. As noted earlier, the bonds do provide some diversification benefit to high-quality bonds. And while high-yield bonds wouldn't be impervious in a period of rising interest rates, as Morningstar associate director of fixed-income analysis Miriam Sjoblom recently pointed out, their extra yield cushions would most certainly hold them in better stead than gilt-edged Treasuries in such an environment. And bank-loan funds offer built-in protection against rising interest rates, as Morningstar senior fund analyst Sarah Bush discusses in this video. If the economy continues to strengthen, high yield and bank loans would likely continue to chug along.

But it's also a mistake to assume that a bond is a bond is a bond. If you're looking at mutual funds that delve into credit-sensitive sectors, it's crucial to thoroughly understand a prospective holding's strategy and downside potential before adding it to your portfolio. Morningstar's fund  Analyst Reports do a good job of providing an overview of these factors, and the Portfolio and Ratings & Risk tabs for individual funds also help you dive into an investment's behavior and characteristics.

To help investigate whether an investment would be additive or redundant with something you already own, you can trial-run it in your portfolio by clicking the "Add to Portfolio" button on Morningstar.com. (You must already have a portfolio saved on the site to use this feature.) Another good resource is to check a specific investment's correlation with another, using this tool on assetcorrelation.com. For example, if you're considering  Loomis Sayles Bond (LSBRX), you can check its correlation with a total stock market index fund such as  Vanguard Total Stock Market Index (VTSMX). In so doing, you'd see that its equity-market correlation has trended up steadily for much of the past decade. That may not be a permanent condition, and it doesn't override Loomis' merits. But it's definitely something to bear in mind before making the buy.

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