Bond-fund investors need to focus on duration, credit quality, and relative yields to better understand how much risk they're taking on, says Morningstar's Eric Jacobson.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With bond yields as low as they are right now, many investors are concerned that rising bond yields could hurt bond prices. Joining me to discuss how to assess the risks in your bond portfolio is Eric Jacobson. He is a senior analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Hi, Christine. Good to talk to you.
Benz: Eric, we usually think of there being too key risk metrics that you want to focus on when evaluating a bond fund: the interest-rate sensitivity and the credit quality. Let's start with interest-rate sensitivity, and one of the statistics we provide on Morningstar.com is duration. A lot of people are looking hard at duration these days. Let's talk about what that measure is and how it may indicate whether a portfolio is risky or maybe a little less risky?
Jacobson: We'll as lot of folks know, duration is an estimate of how much interest-rate sensitivity your portfolio is going to have should market yields move up or down. Generally speaking what you want to do is look at the duration number, let's just say for example that it's 2.5 years, and multiply that by 100 basis points, or 1%.
What we at that point say us if interest rates move up, for example, 1 full percentage point, you would expect the fund to lose about 2.5% based on that duration and vice versa. Now, the most important thing I think for a lot people to realize is, it's not a foolproof number. It's a mathematical construct. It is a modeled number. It isn't perfect, and it doesn't necessarily account for changes in interest rates in every scenario. Sometimes, it's because shorter rates move up. Sometimes, it's because longer rates move down, things like that, but it is a pretty good estimate of what you can expect in a short shock of interest rates in one direction or the other.
Benz: So, the thing is though if interest rates move up, I get some of that back in the form of a higher yield. So, even if my principal values on my bonds might be depressed in my portfolio, my manager or I, if I'm buying individual bonds, am able to obtain new bonds with higher yields attached to them, right?
Jacobson: That's right, and you know, there are studies out there--Vanguard has had one from a couple of years ago, for example--that show different interest rate paths and how portfolios tend to recover reasonably quickly from interest-rate shocks. We should be careful not to try and scare people too much over the longer term. You're generally going to make out OK with your bond portfolio, but I think the one thing people need to realize is if under certain scenarios, if we do have a quick and large rate shock, you are going to have a period of perhaps very poor performance in a bond portfolio.
<TRANSCRIPT>
Benz: Are there bond-fund categories where duration is a less useful measure, where I should probably take it with a grain of salt?
Jacobson: Absolutely. Any area outside of the traditional government area, so in other words short-, intermediate-, or long-term government bonds--those are places where it tends to be most reliable unless there is lots and lots of mortgages in the portfolio, and it can slip around a little bit. But when you stretch over to, for example, multisector bonds and even more importantly, high-yield bonds, you start to get to points where even though the math is right technically, the fact that those markets don't move as tightly to the Treasury market means that you don't need to pay as close attention to it. So, for example, a high-yield fund might float around in the 3-6 year range, but probably isn't going to be quite as rate-sensitive as a 3-6 year core or high-quality bond fund. You want to pay much more attention to what's going on in the credit markets when you're evaluating a fund like that.
Benz: That segues to my next question, credit quality, the other metric that investors pay a lot of attention to when thinking about the riskiness of their bond holdings. Morningstar.com provides a few different statistics related to credit quality of a bond portfolio. One is that average credit quality and then you can also see how your funds holdings shake out in terms of the various credit quality rungs. How should investors use that data when they are thinking about their portfolios?
Jacobson: Well, the average credit-quality rating is really just a quick hit. It's a weighted average based on default probability for, in particular, corporate bonds. So, I'd be careful putting too much emphasis on that because you are going to see a lot of portfolios where because the default probability for junk bonds is so much higher statistically over the last decades, that average credit-quality number is going to be pretty skewed. And pretty much any portfolio that's got a little bit of junk bonds in it is going to come up with a pretty low average credit quality.
Just as important arguably is what the breakdown of credit is from the different strata. So, hopefully a lot of investors are familiar with the fact that AAA is the highest quality then you go down to AA, A. Then it goes to BBB. That's the breaking line between what we think of as investment-grade and high-yield.
So BB, B, CCC, those are the high-yield strata on the way down. You want to compare your funds if you're looking to try and understand which one has more or less risk than the other in terms of what the percentages are in those different strata.
Benz: You also say sector weightings can work hand-in-hand with some of those credit qualities. How should investors look at that data? A, should they find the most current data, and B, what should they make of it when they see how a funds is apportioned among government bonds, corporate bonds, and so forth?
Jacobson: Sure, well I would say often the best place to look for an updated sector weighting is at the fund company website. Almost every fund company now does a pretty good job of putting those on their websites. The thing you want to keep an eye on is what kinds of sectors--in particular the basic ones like governments and corporates are pretty self-explanatory. But if you see things like commercial mortgage-backed securities, emerging-markets debt--in particular emerging markets is a good example, because there are cases there where they tend to be a lot higher rated than they used to say 10 years ago, because so many of those emerging markets have done better on their fiscal health.
On the other hand, they tend to still be pretty volatile in the marketplace. So even though you may not see anything too suspicious on the credit side, if you see a reasonably large weighting of emerging-markets bonds in that portfolio, you know it has a possibility of being a little bit more volatile and potentially dangerous in a big sell-off.
Benz: The last point that you think investors should focus on when they are evaluating the risk of their bond funds, it's a little bit counterintuitive, and this is yield. People usually think of a robust yield as a good thing, but you say it can also flag excessive risk-taking, or at least some risk-taking. Let's talk about why investors should take a look at a fund's yield.
Jacobson: Hopefully if you're really into triangulating on these different risks, you're going to see the roots of this risk, either in the duration somewhere or in the credit-quality strata or in the sector weightings. You can usually backtrack to them, but the bottom line is this: If you see a yield that is significantly higher than a peer group or tends to hang around the top of the peer group, you can bank on the fact that there is some extra risk built into that portfolio, whether it's liquidity risk, or sector risk or quality risk or what have you, it's in there. That is pretty much the telltale sign; it's not a calculated number in the sense of a modeled number like duration. It isn't skirting around a lot of things. That's the big number at the end of the day that tells you whether or not there's risk in the portfolio, because there is no free lunch. So that's one that if you look at everything and you can't see the risk, but you see it showing up in the yield, you want to ask more questions and try to understand why it's there.
Benz: Eric, we've seen a lot of flows going into those higher-yield categories, recently emerging-markets bonds, multisector bonds, junk bonds et cetera. What's your counsel to investors who have been gravitating to those fund types over these past few years?
Jacobson: I would say be really careful. Chances are you've been very fortunate and made a lot of money in those, if you've done it over the last few years. And I would counsel not to be greedy because we're getting to the point where these 'spreads,' in other words, the amount of extra yield that these sectors are paying above and beyond government bonds are relatively tight or narrow relative to the government sector for example. That means that your margin for error just isn't there.
Now the good news is, is that if you talk to different managers, a lot of them think that we're not yet in the spot on the credit cycle where there's a lot of risk to those spreads blowing out, if you will, and when spreads blow out, what that means is credit markets tend to sell off relative to the higher-quality strata. And as I say a lot of managers don't think we're in that neighborhood yet.
The signs that we usually start to see are easy money, in other words, corporations and issuers getting to sell bonds into the high-yield and leveraged-loan markets, for example with very loose terms, much less high-quality business plans, things like that. You're starting to see that and hear about it, trickle in there a little bit, but we haven't got into a wave of it yet, where you'd say, "Boy, this market is really taking on a risk flavor." But that's the kind of thing that's going to start to happen most likely over the next couple of years, and you really want to be cognizant of that and don't try to squeeze out the last bit of return by piling extra money into these areas where money has already been chasing.
Benz: Eric, well it sounds like your bottom line is if you are embracing any type of bond fund right now, just be sure of the risks that you're taking.
Jacobson: Absolutely. The most important thing is to try as best you can to understand what's in your portfolio, otherwise you really got to trust your manager who knows what they are doing and that's kind of an uncomfortable place to be if you don't know what you hold.
Benz: Eric, thank you so much for being here.
Jacobson: My pleasure, Christine. Great to talk to you.
Benz: Thanks so much for watching. I'm Christine Benz, from Morningstar.com.
