Will Your Bond Holdings Come Through in the Clutch?

Bond investors have been battening down the hatches for the past five years, waiting for rising interest rates to materialize. They've been stress-testing their portfolios' durations, swapping into cash in lieu of bond funds, and jettisoning long-term bonds. There has been an opportunity cost to this caution, as the yield on the 10-year Treasury bond has actually dropped during the past five years. Recently, however, bond yields have traced their way back up amid a strengthening economy and the supposition that the Federal Reserve would likely begin raising interest rates later this year.

Yet, in their quest to protect their portfolios against interest-rate sensitivity, investors must be careful not to forget about other bond risks, especially credit-quality risk. Most investors understand that junk-bond and bank-loan funds, as well as multisector vehicles, court substantial credit-quality risk and correctly relegate these positions to the margins of their portfolios. But they might be surprised to see that credit risk extends to other portions of their portfolios, including short- and intermediate-term bond and allocation funds. Fund managers have been shoved out on the risk spectrum in their quest for yield and their desire to deliver a positive return after fees, but investors must remember that their goals for their bond portfolios may not be the same as their fund managers'. While many fund managers may prioritize a decent (or at least positive) yield in all market environments, investors typically view their bond portfolios through the lens of their total portfolios--that is, they look to their bond holdings to lose as little as possible, or perhaps even gain, during equity-market shocks. And on that score, some bond portfolios may not deliver.

Why This Is an Issue Asset-allocation guru Bill Bernstein's intuitively appealing definition of risk is "bad returns in bad times." Seen through that lens, bond funds that take credit-quality risk are, in fact, courting even more risk than portfolios with extra interest-rate sensitivity. While high-quality bonds--especially long-duration bonds--have a tendency to hold up well when the economy and equity market tank, junkier bonds often move in sympathy with the economy and the equity market. Thus, investors whose fixed-income portfolios lean too heavily toward lower-rated credits risk having everything fall at once: their stock holdings, their bond holdings, and even their own career and job prospects.

If investors own bonds to be shock absorbers for the high-risk piece of their portfolios, junkier bonds aren't likely to deliver. In 2008, the Barclays U.S. Aggregate Bond Index gained more than 5%, even as high-yield, bank-loan, and multisector-bond funds lost 26%, 30%, and 15%, respectively. Even intermediate-term bond funds, which tend to court more credit risk than the Aggregate Index, lost 5%, on average, that year.

Of course, the U.S. economy remains pretty healthy by many measures, meaning that rising interest rates are likely to be a major headwind for bond investors in the years ahead. But it's worth noting that junky bonds may not fare that well in a rising-rate environment, either. The fact that lower-quality bonds typically pay higher coupons to compensate for their credit risk has historically made them less sensitive to interest-rate changes than higher-quality bonds with lower coupons. But the scramble for yield has meant that the yield differential between junk bonds and Treasuries is quite low relative to historic norms--not quite as low as they were last summer, but still pretty low.

Not Just the Usual Suspects It's not a news flash that high-yield bonds--and, to a lesser extent, bank loans--are credit-sensitive holdings that are best used as supporting players in a fixed-income portfolio anchored by high-quality bonds. Multisector-bond funds are also generally understood to have a fair amount of credit exposure.

The real risk is that some investors may be inadvertently edging out on the risk spectrum with their core bond portfolios as well. The median funds in the short- and intermediate-term bond categories have average credit qualities of BBB, for example. (From highest to lowest, Morningstar's average credit qualities are AAA, AA, A, BBB, BB, and B; anything at BB or below is considered junk.) A BBB rating is not junk, but it's the lowest tier of investment-grade. Meanwhile, 14% of short-term bond funds and 17% of intermediate-term funds have average ratings of BB or below.

Not surprisingly, funds in the non-traditional-bond category, which some investors have looked to as an alternative to core fixed-income funds to take the edge off in a rising-rate environment, have even junkier portfolios. The median fund in the group has a BB average credit quality, and 15% of the funds in the category have average credit qualities of B. As discussed here, investors could be escaping interest-rate risk with these products, while fully embracing other types of risk.

It's also worth keeping an eye on the credit risks that could lurk in allocation funds, as discussed in this article. The median fund in the moderate-allocation category had a BBB average credit quality as of its most recently available portfolio, whereas the median funds in the conservative- and aggressive-allocation groups had average credit qualities of BB.

Investors should be aware that Morningstar's methodology for average credit quality is not a simple average; lower-quality bonds take up a greater weight in the calculation, dragging down the average credit qualities for funds that have them. (This paper discusses Morningstar's fixed-income style box and credit-quality calculation in detail.) Nor is this to suggest that fund managers have thrown risk controls out the window; most bond managers have their eyes on the downside and believe that credit risk is worth taking at this juncture. To be sure, credit-quality risk has been well rewarded in the past six-plus years.

That said, bonds have had a fine run in absolute terms, making it an ideal time to get in there and look closely at all of the risks that lurk in your portfolio today. An above-average yield should always be a signal to dig into sources of risk: interest-rate sensitivity, credit quality, sector, and liquidity. This article delves into how to conduct a risk analysis of your bond portfolio, and Morningstar's fund analyst reports also discuss risks--both the overt ones, such as junky portfolios or lots of interest-rate sensitivity, as well as more subtle risks like liquidity risk.