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Investing Specialists

Worried About Bond-Fund Risks? Get Ready to Sleuth Them Out

Tips on using past performance, portfolio data, and yield to gauge your holdings' potential trouble spots.

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The bull market for stocks celebrated its six-year birthday on Monday. However, the equity rally is but a wee child alongside the bond bull market. Long-term U.S. bond yields climbed to nearly 15% in 1981, but they've declined for the better part of the past 35 years. As a result, the Barclays U.S. Aggregate Bond Index has posted a negative return in just three calendar years since 1980, and even those losses were remarkably small: 3% in 1994, less than 1% in 1999, and 2% in 2013. 

The net effect of this long and hospitable period for bonds is that investors can be lulled into a sense of complacency over the asset class. And even the ones who know that bonds won't always have it so good may struggle to determine how their bond investments might behave in a more trying period. Whereas a glance at 2008 results can provide equity investors with a shortcut way to assess the risks in a prospective or current holding, bond-fund investors need to dig a little deeper to gain knowledge of the risks that could lurk within their portfolios. 

The answer isn't to omit bonds from your portfolio entirely, as high-quality bonds can serve as valuable shock absorbers, potentially even gaining value when stocks fall. (That's not something you'll get with cash.) But given that the bond party is apt to be much closer to its end than the beginning, it's a good time to take stock of those risks. Here are some guideposts that investors can use to conduct their own due diligence. 

The Surgical Time-Period View
Because bonds have had it so good for so long, trailing-period returns will tend to look pretty rosy overall. Even for bond funds that buy low-quality credits, such as  Loomis Sayles Bond (LSBDX), their abysmal 2008 losses have been obscured by strong returns ever since, as investors have been in "bring on the risk" mode. Thus, investors who aim to sniff out risks by examining past performance will want to focus on a few specific time periods. 

2008
Just as performance during this bear-market year serves as a great gauge for the riskiness of equity funds, it also provides a good depiction of the economic sensitivity and liquidity of bond funds. Lower-quality bonds suffered losses on par with equities in some cases, so a very poor showing that year--in either absolute or relative terms--could be a signal that a fund maintains a junky portfolio. Even funds that don't reside in the high-yield, multisector, bank-loan, or non-traditional-bond categories struggled that year due to outsized exposure to lower-rated corporate or mortgage-backed bonds. But junky portfolios weren't the only ones to struggle in 2008. That year also proved challenging for high-quality but less-liquid bond types such as Treasury Inflation-Protected Securities and municipal bonds; as large investors had to unload them to meet redemptions in a hurry, they were forced to sell them at fire-sale prices, thereby depressing returns across the sectors. Of course, many funds cleaned up their acts following unexpectedly large 2008 losses, so a weak showing that year shouldn't automatically signal a risky portfolio. At a minimum, however, investors who see steep 2008 losses should take a look at what risk factors lurk inside the portfolio. 

The Second Quarter of 2013
Whereas 2008 highlighted which funds were running with lower-quality bond portfolios, the second quarter of 2013 punished those funds that were sensitive to interest-rate changes. The Barclays U.S. Aggregate Bond Index lost 2.3% during the quarter, whereas more rate-sensitive bond types lost much more than that. For example, long-term Treasury funds lost 6%, on average, during that three-month period, and the typical Treasury Inflation-Protected Securities fund lost just as much. If you're concerned about how your fund will behave in a rising-rate environment, examining its performance during this time period--and comparing it with its category peers--can help you know what to expect. 

The Portfolio View
Ultimately, a fund's portfolio will provide the best forward-looking view of the risks that could lurk in its future. After all, a fund's manager or strategy may have changed since the last challenging bond market environment, so its past returns may not apply. Fund prospectuses, meanwhile, will typically cite a laundry list of risk factors, some of which are likely to be relevant to the particular fund and some that are much less relevant. 

A fund's portfolio, by contrast, provides many relevant clues about what to expect going forward. Here are the key elements to focus on. 

Duration: For high-quality bond funds, duration can provide a quick-and-dirty way to assess how interest-rate changes are apt to affect a portfolio. You often hear that a fund will lose roughly as much as its duration in a one-year period in which rates trend up by one percentage point. That's a good start, but it doesn't take into account that the investor also benefits slightly in a rising-rate environment because the yield itself ticks higher when rates go up, thereby offsetting the decline in the bonds' prices. This article discusses how to conduct a quick duration stress test of your holdings, as well as the limitations of the stress test for some types of bond funds. 

Credit Quality: As yields have slunk lower over the past several years, many funds have dipped down the credit-quality ladder in an effort to plump up their payouts. That's been a good bet to make: The economy has strengthened, and with it, the prices of lower-quality bonds. The opposite scenario, meanwhile, will tend to be challenging for lower-quality bonds and can lead to real losses. Many core-type short- and intermediate-term bond funds have specific parameters around how much they can invest in true junk bonds--those rated BB and below. That said, it's not unusual for such funds to have average credit qualities in the BBB and A range; such bonds will tend to fare worse than AA and AAA rated bonds in a flight to quality like 2008. 

Foreign-Bond Exposure: Morningstar's Portfolio page will also depict whether a fund owns foreign bonds. This is not a big risk factor in and of itself, particularly if the fund owns dollar-denominated bonds from high-quality issuers in developed markets. But if you see a large slug of foreign bonds in a portfolio, it can be worth doing a little more digging. Are the bonds denominated in dollars or foreign currencies? The latter can bring more volatility--for example, foreign-currency-denominated bond funds have recently slumped amid the dollar's ascent. Does the fund own bonds from developed or developing markets? Does it own foreign-government bonds or corporates? (Both developing-markets and foreign corporate bonds will tend to be more volatile than government bonds issued by developed-markets nations, though past is not prologue: Foreign governments in developed markets have plenty of problems, too.) 

Exposure to Other Asset Classes: Morningstar's Portfolio tab will also provide a view of a bond fund's total asset allocation, which can also provide clues about its prospective risks. For most high-quality core-type bond funds, the portfolio will be denominated by bonds but may also feature a small stake in cash, either to offset the risks elsewhere in the portfolio or because bonds have matured but haven't yet been replaced. However, for more exotic bond-fund types--such as nontraditional, multisector, and high yield--the portfolios may include exposure to stocks as well as "other" asset classes, usually convertibles and preferred stocks. As with lower-quality bonds, exposure to these asset classes will tend to heighten volatility in weakening economic environments and/or when equities sell off, though it can enhance returns when times are good. 

Yield: Many investors shop for bond funds based on their yields, but the connection between a higher yield and higher risk is pretty direct and intuitive. Yield is so scarce these days that you can bet that if investors could find higher-yielding bonds without a lot of extra risk, they'd snap them up in a hurry, pushing their prices up and their yields down in the process. Of course, some funds deliver higher yields than their peers because their expenses are lower; but in the absence of low expenses, a high yield relative to category peers will tend to indicate extra risk-taking. Morningstar.com doesn't provide benchmarks for assessing whether a fund's yield is high or low relative to its peers, so here are median SEC yields for a few categories; you can use them to gauge whether your fund's yield signals that additional risks could be present. 

Intermediate-Term Bond: 1.73% 
Short-Term Bond: 0.67%
Bank-Loan: 3.29%
Multisector Bond: 3.10
Nontraditional Bond: 1.30%
Muni-National Intermediate: 0.89%

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.