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By Jason Stipp | 11-15-2011 12:00 AM

Handbook for Hands-On Bond Investors

Morningstar's Christine Benz on what to know before going tactical with your fixed-income holdings.

Jason Stipp: I'm Jason Stipp for Morningstar. With the threat of rising interest rates on the horizon, a lot of bond investors are worried about their portfolios and want to take steps to protect them from potentially higher rates in the future.

But before you get going, Morningstar's Christine Benz has a checklist of pre-flight considerations that you should take a look at.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, we do have a very interesting fixed-income environment, a very difficult fixed-income environment. We do know that a lot of investors want or feel like they need to be more hands-on with that portion of their portfolios. But your first point really is that they might not necessarily need to be that hands-on. They might actually already have an element of tactical baked in?

Benz: That's right. So, even if your fund isn't overtly calling itself "unconstrained," or "go anywhere," or "all authority," or something like that, it still may have a tactical component.

So, when you think of some of the biggest actively managed core bond funds out there, they are pretty free-ranging, whether it's Bill Gross' PIMCO Total Return/Harbor Bond, MetWest, Dodge & Cox--those are all pretty much free-ranging funds that have a lot of latitude to go beyond whatever the Barclays Aggregate Bond Index is telling it to do.

So, that would be my first point. If you have actively managed funds, check up on what they're doing, how they are managing their portfolios. They may be quite tactical in and of themselves. So, you may not need to do a lot of jockeying on your own; you're essentially just delegating that decision-making to your professional money managers.

Stipp: So, you can basically stick to what would be your strategic portfolio allocation, but know that these managers that you've outsourced these particular funds to, might be making some adjustments to try to fend off some of those rising interest rate risks?

Benz: Right, and actually we've seen this in action year-to-date. We had a period this summer, for example, where Treasuries really trumped everything else. The typical portfolio manager with shorter duration didn't have as much Treasury or mortgage-backed bonds in the portfolio and badly lagged the Aggregate. So, this is very much going on right now in many of the core actively managed funds that are widely owned.

Stipp: So, Christine, at a high level, if you were looking at a fund on Morningstar.com, how would you know what kind of bets that manager was taking, to get a sense of how active they're being and how different they are from that Barclays Aggregate Index?

Benz: You can find that right on the portfolio page for that particular fund. You can see its sector weightings laid out in terms of government, corporate bonds, Treasury or mortgage-backed bonds, etc. So, you can see how it's positioned versus its benchmark as well as versus its category peers.

Stipp: In Morningstar Analyst Reports, the analysts also often discuss particular bets that the fund managers are taking, so it could be good to check up on those as well.

So, let's say that you have looked at your bond portfolio, and you just don't think that you're really that different from, for example, the main index, the Barclays Aggregate Index. And you are inclined to be more hands-on and to take some bets. Where should you start? How should you think about what to do with this portfolio now?

Benz: I think, the first step is really to think about what you're doing at that point. If you decide to proceed in adding some tactical exposure or making some tactical maneuvers, think about the idea that you're essentially betting against other bond market participants.

So, the bond market is a fairly efficient mechanism, really pricing in various risks all day long. So, by saying, "OK bond market, you are pricing bonds in a certain way, but I think that they will move differently," and you're betting against a lot of pros.

So, I think you just want to take into account the fact that you could be wrong, because you are essentially saying bond prices reflect one scenario, I think they'll go another way. So, just recognize that the odds could be against you as an individual investor making such a decision.

Stipp: At Morningstar, we know that our analysts have looked at a lot of active managers and the strategies that active managers employ when they are going to take bets and be contrarian. What are some of the signposts of strategies that have worked in the past? It doesn't mean they're easy to accomplish, but what has generally been a good way to be tactical in the market?

Benz: I think the key thing to think about is being valuation conscious. So, assuming that you want to go forward and have some sort of tactical bent to your fixed-income portfolio, think about going where the values are and taking money off the table where they may not be. And for bond market participants, yield is a really nice, but rough proxy of valuation. But generally speaking, where yields have gotten very compressed, are the sectors where you might want to think about lightning up your exposures. And where yields are relatively more robust, those are spaces where you might want to think about adding.

Stipp: So the bargain-hunters, the ones that look for something that's $1 selling for $0.50, for example, have traditionally done well for those who can execute it well.

Last question for you, Christine, I think that there are some broad expectations for what interest rates might do in the longer term and that Treasuries might not be the best place to be, but implementing it on a personal level, it depends more also on your personal situation, and what your time horizon is, instead of just where you think the broad market is going to go.

How would you swing some of those tactical moves depending on where you are in your life stage?

Benz: I think that's a really great point, Jason. So, if you are inclined to be tactical and you have a fairly short time horizon, so maybe this is money that you expect to need within the next five to 10 years to fund your living expenses, it seems like you'd want to shade any tactical bets to the conservative side.

So, if you're concerned about rising rates, then it would argue for shortening up your fixed-income portfolio, not steering money toward a bunch of corporate bonds. You might just want to keep it fairly high-quality but shorten it up.

If you have a longer time horizon and that bond portfolio isn't just ballast for you but also a partial total return engine, perhaps you could look to bulking up the credit-sensitive sectors of your portfolio, taking money off the table in Treasuries, keeping duration intermediate term or whatever, but definitely shading more toward corporate bonds, toward junk bonds, bank-loans, more credit-sensitive sectors.

So, I think that gauging who you are and what that bond component of your portfolio is trying to do for you is a key aspect of getting any tactical maneuvers right.

Stipp: So it sounds like the bottom line, especially with tactical, is that a lot of these things, even when managers are right, can take time to play out, and as we've even seen this year, managers can be wrong in the short term, and if you have that short-term time horizon you could get caught against a trend?

Benz: Exactly. So, you want to make sure that you have an appropriate time horizon in mind as well.

Stipp: Okay. Thanks, Christine for these tips on being more hands-on with your fixed-income portfolio.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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