Find the Bond Mix that Suits You Best

The following commentary originally appeared in the Sept. 6, 2007, issue of Morningstar Mutual Funds, Morningstar's flagship resource for serious fund investors. Click here to learn more about Morningstar Mutual Funds.

The principle of investment diversification has been an objective of mutual funds since their origin. In fact, one study points out that the world's first mutual fund (a closed-end fixed-income fund launched in Amsterdam in July 1774) had diversification among different investment types as an explicit requirement. Beyond not wanting to have too much capital at risk in any single investment, diversification functions due to distinct asset classes often behaving differently. For instance, stock and bond returns aren't well correlated, so the combination of the two asset classes can lower portfolio volatility (an aspect of risk) while not excessively sacrificing return.

But why sacrifice any return potential at all? If investors were not risk-averse, then perhaps it would make sense to stick solely to stocks. However, our internal research suggests that investors are quite risk-averse, and tend to fare poorly in volatile investments. Our studies of Morningstar Investor Returns, also known as asset-weighted returns, indicate that the average return experienced by the typical investor in volatile funds is worse over time than in funds that are less volatile, and this seems to be the case among categories as well as within them, a fact that strongly argues for volatility reduction in investors' portfolios. To that end, we'll examine different types of diversification within the fixed-income universe, such as credit quality, interest-rate exposure, and country and currency, with an eye toward showing investors how to diversify from core intermediate-term bond funds to achieve better actual results.

Credit Quality Diversification
Investors look to high-yield bond funds not only to enhance returns (lower-quality debt carries a higher coupon to compensate investors for added default risk), but also for diversification. High-yield bond funds, for example, display less sensitivity to interest-rate changes than high-quality bond offerings, but do display a higher correlation to equity markets. We looked at correlation coefficients (which are past-performance-based metrics ranging from 1.0, indicating perfect correlation and no risk reduction potential to -1.0, indicating perfect negative correlation, and maximum risk reduction potential) between the high-yield bond category and other taxable bond categories for the 12-year period ending July 31, 2007. This period included equity bull and bear markets, periods of rising and falling interest rates, variance in the credit and business cycles, and several dramatic "shocks" to global equity, fixed-income, and currency markets, in other words, a good test case. We found that high-yield funds' returns were least correlated to the higher credit-quality categories. Intermediate-term bond funds, which play the role of core fixed-income holdings for many investors, displayed low correlation (0.23) to high-yield, for example. However, investors adding high-yield should look carefully at the mandates of their core bond funds to make sure the funds don't invest heavily in high-yield (some do), which could create unintended overexposure to that category. We also found that the high-yield category was one of the most positively correlated with stock returns (using the S&P 500 as a proxy), at 0.57, while intermediate-term funds displayed high (0.03) noncorrelation with the equity market.

Added portfolio diversification does not entail the elimination of risk, and therefore it is vital to understand the risks each particular fund in a portfolio takes and how the various risks operate together. While the preceding example illustrates how bond funds of varying credit quality will act differently from one another, investors should be very careful when investing in high-yield funds, as volatility tends to be higher than with other bond categories, and as the average category return in 2000 showed (a loss of 6.61%), substantial capital losses are possible. Therefore, we suggest keeping investments here modest (no more than 5% to 10% of total portfolio assets), and we think investors should stick to funds with well supported, and experienced, management teams that take a more cautious approach.

Interest-Rate Diversification
Based on our examination of correlation coefficients, investors seeking fixed-income diversification will benefit less from buying funds with varying interest-rate sensitivities than they will from adding some credit risk. A common measure of a fund's sensitivity to interest-rate movements, referred to as duration (measured in years), indicates how much the average price of a bond in a portfolio will change for every 1% change in interest rates. For example, a duration of 7 years implies that the average price of a bond in the portfolio will rise or fall by 7% for every 1% change in rates. Thus, funds with longer duration measures are more sensitive to rate changes, and tend to be more volatile, and those with shorter durations can be seen as more defensive on interest-rate risk. And while we see some modest diversification potential when looking at fund categories with varying durations, the difference is much less pronounced than with credit quality.

For example, the correlation of returns between the intermediate- and long-term bond categories is high at 0.96. Even the difference between the long- and ultrashort-term bond categories, at 0.53, isn't dramatic, though it does suggest the relative protection short-duration funds can provide in a rising rate environment. Of course, another point to consider is that these return correlations (this also applies to the other two sections) aren't solely driven by interest-rate factors here (that is, the factors aren't isolated), so credit quality and a variety of other elements are also at play in the numbers. Nevertheless, the aggregate elements factoring into the return correlation statistics suggest that taking interest-rate risk provides more modest diversification potential than does credit risk. Of course, due to differing volatility levels between long- and short-duration funds, investors should be careful to match duration to their objectives. For instance, one should look to short-duration funds for short time horizon needs.

International Bond Diversification
International bonds can also add useful diversification to investors' portfolios, as foreign bond markets' performance will often not correlate with domestic fixed-income returns. And if portfolios are denominated in different currencies, international bonds also provide investors with foreign currency exposure, further diversifying returns. In the world bond category, for instance, funds hold sovereign debt issues, often fully or partly unhedged, and occasionally emerging-markets bonds, so the category holds a reasonably low correlation (under 0.60) with six out of 13 taxable bond categories, and only a 0.14 return correlation to U.S. equities. Likewise, the emerging-markets bond category holds this low correlation to the return moves of 10 of 13 taxable bond categories, though its returns correlate more to high-yield and equities. Again, we find that credit quality has a greater impact on return correlation within fixed-income categories even among international categories, as world bond tends to correlate more with higher-quality domestic categories, and emerging-markets bond tends to correlate with other risk sectors, like high-yield.

The differences in return movements are the result of a number of factors, including national variability in business and interest-rate cycles, in inflation expectations, and currency fluctuations. Some argue that globalization, and the resulting convergence of many aspects of local economies, one to another, will diminish the diversification potential of international bonds. We think historical correlations need to be judged carefully (with all historically based data, nothing guarantees similar behavior going forward), but there's ample evidence to suggest many funds in the world- and emerging-markets-bond categories will continue to act differently than domestic counterparts. For example, some managers could venture further afield into "frontier" emerging markets, and others could venture into local currency debt, both of which should provide amply diverse returns.

A Note on TIPS
Finally, one interesting finding is that funds in the Inflation-Protected Bond category don't seem to offer much diversification benefit away from the higher-quality domestic categories, including intermediate-term bond, where there's a 0.82 correlation. TIPS funds do, however, offer one of the highest levels of noncorrelation to equity markets, making them a good addition to a well diversified portfolio.

Take Away
Investors should keep the bulk of their fixed-income portfolio in well-run, high-quality, and less costly core bond offerings; such as Morningstar's intermediate-term bond  Fund Analyst Picks. That said, adding supplements, as we've seen, can mitigate risk and enhance return, if used judiciously.