If Stocks Are Bad, Why Are Junk Bonds Good?

Compartmentalizing
Everyday investors don't trust stocks. Yesterday, Franklin Templeton asked in an advertisement, rather plaintively, "Is it time to put your money to work? Time to take stock." (A pun!) Merrill Lynch and Wells Fargo bosses are urging advisers to overcome their clients' skittishness about equities. Over the past 12 months, net sales of stock mutual funds have been barely positive, while bond funds have picked up another $300 billion. The shadow of 2008 continues to linger over stock investors.

Yet high-yield bond funds are popular. Cash flows into "junk bond" funds have been consistently positive, running at $10 billion for the trailing 12 months (representing a 4% growth rate on the category's current assets of roughly $250 billion). The Wall Street Journal's Jason Zweig reports that plan sponsors are currently considering whether to add high-yield bond funds (among other specialized fixed-income funds) to their lineups.

I'm not able to square this circle. High-yield bond funds might be called bonds, and stock funds might be called stocks, and, yes, they show up as different colors on a pie chart...but they're much more alike than different. In 2008, high-yield bond funds diversified the plunging stock market to the tune of negative 26%. Junk bonds then roared back to life in 2009--the same time stocks roared back to life. Essentially, junk bonds are yield-cushioned stocks. There's little if any reason to like one security but not the other.

When Number 1 Isn't Good Enough
You'd think that having the best-performing 2010, 2020, 2030, and 2040 target-date funds in the business over the trailing 10 years might be worth celebrating. After all, if an index fund places in the top quartile for a decade, its proponents* heartily congratulate themselves for their collective wisdom. So surely landing in the very top percentile must merit dancing on the table, along with perhaps an impudent comment aimed at the funds' detractors.

(In fact, top percentile for the decade understates the funds' accomplishments. Consider the T. Rowe Price Retirement 2020 (TRRBX) fund's annual performance ranking against other funds in its category, with 1 being the top percentile and 100 the worst.

Eight years out of 10 in the top decile, never landing in the bottom third. Peter Lynch was never that good.)

T. Rowe's response? An implicit apology. This month, T. Rowe launched a second series of target-date index funds that follows a different strategy than does its current series. As it turns out, Price can't sell its current series to all plan sponsors. A significant number of sponsors won't bite despite the great performance numbers, because the T. Rowe Price funds have ... too many stocks. Yep, those bad, bad stocks again.

* Including yours truly. My largest fund holding, by far, is Vanguard Total Stock Market ETF (VTI). 

Friendly Fire
If you haven't seen David Snowball's Mutual Fund Observer, take a look. David is a veteran who knows of what he speaks, and he's not afraid to bite. He'll be at Morningstar's Investment Conference next week, using the opportunity to meet with the media and spread his story, but that didn't stop him from nipping at Morningstar in his most recent issue (for, in David's view, poor labeling of a data point). Good for him--who wants a fearful columnist?

Don't Call It "Frisco"
State Farm is currently running a Chicago radio ad campaign that is so stereotyped, so patronizing, that I half expect Saturday Night Live's Ditka Super Fans to be wheeled out as real-life Chicagoans. Per State Farm, we locals chow on deep dish pizza and cheeseburgers, and spend our weekends listening to blues and looking at the Bean. 

Why stop with Chicago, State Farm? How about telling New Yorkers how great it is to reside in the Big Apple, where you can hit Rockefeller Center and the Empire State Building, and then have a Coney Islander? And there's always Frisco, where you can visit Alcatraz by day, Fisherman's Wharf at dusk, and then the Redwood Room at night.

Sheesh.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.