Jason Stipp: I'm Jason Stipp for Morningstar. It's January, so we know a lot of investors are checking in on their portfolios to take stock of performance and assess their asset allocations, but now is also a good time for investors, especially retired investors, to take stock of the risks in their portfolio, and there may be some hidden risk there as well. Here with me to discuss is Morningstar's Christine Benz, she is director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So, I think that when we think of retiree portfolios, there's going to be more fixed income allocation. So, I think that when you're looking at the risks of the portfolio, some people might think well that's the safe part of my portfolio. That's the no-risk part. But that's not true. There are risks they need to think about in terms of fixed-income investments. What are some of those?
Benz: Well, one of the key ones I would point to right now, and this is something it seems like a lot of our users are explicitly attuned to, is this threat of interest rate shocks, and it's something we saw in the fourth quarter of 2010 where interest rates did come up rather abruptly and that led to principal losses for some bond funds. So, I would say it's a good time to survey your fixed-income portfolio, take stock of just what kind of interest rate exposure you have there. Make sure that you're comfortable with that risk level.
Stipp: So, if I'm looking at my investments, what's a good way to stress-test how interest-rate sensitive they are, how much of a shock I might feel if rates do tick up?
Benz: Well, duration is really going to be your guide there. So, for each fund, you'll see a published duration. You want to take a look at that number. Ken Volpert at Vanguard shared a handy rule of thumb, which I'll pass on, and that's subtract the fund's SEC yield from its current duration and that's about how much you could expect to lose in a one-year period if interest rates jumped up by one percentage point.
So, just kind of go through, you'd have to do this work holding by holding, but I think it's worthwhile just to see what kind of real losses you could be in for, and the reason this formula is useful is because that yield does help cushion you. So, even if you see some principal volatility, you pick up a little bit in terms of yield. So, it's a good formula, good starting point for that stress test.
Stipp: So, if I take a look at that, and I feel like, wow, maybe [my portfolio] is just a little bit riskier than I thought, and I want to try to pull that back, it's important to kind of balance that a little bit because there are other risks with becoming too conservative.
Benz: Right, and this is something I have been hearing from a lot of users who say, "oh, why am I going to monkey around? If interest rates are going up, I'm just going to go all short until this blows over. I'd rather be safe than sorry."
I think that that might make a certain amount of sense for a portion of a portfolio. The big risk is, though, is if inflation continues to tick up, and we have been seeing certainly food and energy prices showing signs of going up and those are big costs for most retiree households. Inflation is going to gobble up every bit of what you are earning on your short-term assets, your cash assets, and then some.
So, to me it's probably unwise to be 100% cash and short-term bonds at this point. You do need a little bit of interest rate exposure. And the other thing is with a bond fund, say an intermediate-term bond fund, as rates go up, you are able to pick up a little bit higher yield as that happens. So, that helps offset some of those price declines that you might see.
Stipp: Also important to keep in mind, although there might be some immediate risks that could happen over the next year or two, for a lot of retirees, retirement is a long-term prospect. So, it's more than just this year and next year. They have to think about what the long-term potential of their investments is.
Benz: Right. That's another place where duration can be helpful. So, in addition to doing this interest rates stress test, look at that duration. If it's five years, plan on that being your approximate holding period for that investment. If you have a shorter time horizon, you shouldn't be in that fund with a five-year duration.
Stipp: So Christine another risk that might be on some investors' minds, and this is an interesting point right now because our Fixed-Income Manager of the Year is a global bond fund manager. So, people are thinking globally. They might have more global holdings, including global fixed-income holdings. What risks should they keep in mind on that front, because it's not just U.S. anymore. it's the whole world.
Benz: That's right. I wrote about this earlier this past week, Jason. What I think investors might be surprised to find is just how global some of their bond portfolios are, and I don't want to be overly alarmist, because foreign bonds aren't inherently more risky than U.S., but there are some risks of currency exposure, so if it is a foreign bond that's denominated in the foreign currency, you have to think of your return really being two parts.
So you've got the return that the bond delivers, so any income and capital appreciation or depreciation from that bond, and then you've got the currency effects. So if that foreign currency appreciates versus the dollar in the time that you hold that bond, that's good, and you pick up a little bit of extra return. If, on the flip side, the currency depreciates versus the dollar, you've got a loss.
And so the risk for retirees of a lot of foreign currency exposure is it's just a wildcard that's unpredictable and maybe not something you want with the very safe portion of your portfolio.
So, I say get in there, check up on how much foreign bond exposure you have, but also check up on what the currency effects might be. Some funds hedge all that currency exposure away, so they say we don't want that affecting our return. Other funds just let it ride and let foreign currency effects do what they will. So, check in on what the fund's currency hedging policy is.
Stipp: This might be an important point right now, because a lot of fund managers are seeing worldwide that there are some emerging economies that actually have really very good balance sheets, and they might look attractive compared to U.S., which very obviously has a burdened balance sheet right now. And also a lot of managers think the dollar might be in for a decline over the long term, so more and more folks might actually be looking overseas for this exposure.
Benz: Right, and that's a great point, Jason. It might not be labeled global bond fund in your portfolio; you may see it in that fund that is your core fund. So, check up on how much it has in terms of foreign bonds and also see what the manager is doing in terms of currency exposure.
I checked in with Eric Jacobson, who is our director of fixed-income Research. He said most of the general bond funds using foreign bonds are either hedging it or using dollar-denominated bonds, but he said some might be inclined to get a little cute and try to profit from what they expect will be a decline in the dollar, so they may be unhedged. That's why it's worth checking.
Stipp: Never hurts to scratch below the surface.
Stipp: Christine, thanks so much for joining me today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.