The Temptations and Dangers of Higher-Yielding Funds

Predictions of a much-anticipated "Great Rotation" of assets from bonds into equities have fallen flat so far in 2014. Despite the Federal Reserve’s unwinding of its bond-buying program--at this point projected to be complete in October--long-term bond yields have fallen, with the 10-year down to 2.5% yesterday, from more than 3% at the end of 2013. Meanwhile, flows to fixed-income mutual funds are solidly in positive territory for the year to date, with taxable funds raking in more than $80 billion through June and munis up $12 billion over the same period.

However, there has been a smaller but still important shift in the makeup of the bond-fund universe. That move was on display in 2013 as more than $110 billion in assets flowed out of the traditional "core" categories of intermediate-term government and intermediate-term bond, while $130 billion flowed into the non-traditional-bond and bank-loan categories. And the trend has continued into 2014, with a slight twist. Intermediate-term bond flows turned positive in the first half of the year, but the heaviest flows have surged into non-traditional-bond funds, while the multisector and high-yield categories also took in meaningful sums.

These flows are part of a broader, multiyear trend that has left Morningstar’s taxable-bond universe looking quite a bit different from how it did in the runup to the credit crisis. As the taxable-fund universe nearly doubled from year-end 2007 through mid-2014, all categories saw growth, but investors have increasingly favored funds outside the traditional core universe of intermediate-term bond and intermediate-term government funds. Intermediate-term bond funds took in huge flows in the years right after the credit crisis but are still down to 35% of the universe from 43% in 2007; intermediate-term government funds have gone from 9% to 3% over the same period.

Some of that decline is due to a preference for shorter duration products, while a shift to world-bond funds reflects the increasing globalization of financial markets. But more significant is the flow of assets into more credit-sensitive asset classes. The bank-loan, high-yield, multisector, emerging-markets, and non-traditional-bond categories accounted for roughly 23% of assets in 2007, but by June 2014, their share of taxable-bond dollars was up to 32%.

What’s driving these flows isn’t a mystery. With bond yields low, investors have had to look harder to find income. It’s hard to remember, but the yield-to-maturity on the Lehman U.S. Aggregate Bond Index (now Barclays) stood at close to 5% in December 2007; by June 2014, it was a paltry 2.2%. Meanwhile, those rock-bottom levels, and the occasional encouraging economic signal, have left many anticipating an impending spike in bond yields though rates remain stubbornly low.

But this shift comes with its own risks. The fastest-growing categories are also those with the most credit risk and the highest correlations to equities. Investors relying on the likes of non-traditional-bond and high-yield funds to provide ballast in turbulent equity markets could be in for a nasty surprise; junk-bond funds lost more than 25% on average in 2008 as did bank-loan offerings, and, while most non-traditional-bond funds haven't been around that long, most suffered losses in 2011’s third-quarter equity sell-off. Indeed, the only categories in Morningstar’s taxable-bond universe with negative correlations to the S&P 500 Index over the past three years are those in the government group and the long-term bond category. (Intermediate-term and inflation-protected bond funds have very low correlations). Credit spreads are also tight, so it’s hard to argue that junk bonds and other credit-sensitive investments are a bargain.

What’s the take-away for investors? Those entranced by the yield offered in some of the racier bond categories should expect--and plan for--these funds to add equity sensitivity to their portfolios. And, as always, it’s important to know what you own.