5 Insights for Today's Bond Investor

During the “Not Your Grandfather’s Bond Funds” panel at the Morningstar ETF Conference, participants gave bond investors a few things to think about. Moderated by Morningstar’s Sarah Bush, the panel featured Research Affiliates’ Shane Shepherd, BlackRock/iShares’ Karen Schenone, and PIMCO’s Natalie Zahradnik. Here are some of the key broad takeaways for investors:

Know What You Want Your Bond Allocation to Do When choosing fixed-income investments and setting expectations for them, Schenone recommends that investors answer one question: What is my fixed-income sleeve supposed to do? "You can't just look at fixed income in isolation," she says. Is the goal of your bond allocation to hedge against equity-market risk? To generate income for you to live off? Different goals require different types of bond funds. Investors looking to diversify away equity-market risk would be better-served by a longer-duration Treasury fund than a lower-quality corporate bond fund. Income-seekers, meanwhile, might do well with a smattering of junk-bond exposure.

Index Mindfully Low-cost indexing is indeed an alluring strategy when it comes to bonds. After all, every penny that goes to cover expenses is a penny taken away from return--and these days, there's little return to spare. But the popular broad-based bond-market index has its limitations, say the panelists.

"The Barclays Aggregate Bond Index isn't always a desirable holding," says Shepherd. The index is overweighted in higher-quality, long-duration fare. As such, it's highly sensitive to interest-rate shifts. "We're moving into a period that's going to test indexing" due to duration risk of the indexes, added Zahradnik. "If you're at the front end of the curve, you're going to feel the full impact of rising interest rates.'"

Moreover, although the index is expansive, it's not inclusive: Zahradnik noted that the index doesn't include particular subsets of the bond market that have become more prominent in recent years. "This is an area where we feel it's important to have active management," says Zahradnik. The panelists agreed that investors seeking broad-based bond exposure via one vehicle would be better-served by a fund with an active element to it--whether that's outright active management or a factor-driven strategy. When it comes to getting exposure to discrete subsets of the bond market (such as TIPS, for instance), indexing can make sense, says Zahradnik. "Broad leads itself to strategic and smart beta; narrow to indexing."

Reconsider Your Benchmark Zahradnik noted that managers are moving away from the Barclays Aggregate Bond Index as a benchmark, because it just isn't representative of the broader bond market in which they invest. Instead, says Schenone, managers are switching to the Barclays Universal Bond index, which is more inclusive. (For more about this index, see this article.) Investors with broad-based bond portfolios can take a cue and do the same.

Tread Carefully in the Unconstrained Bond Category Shepherd acknowledges that unconstrained bond funds have become appealing propositions for many investors today, because of skimpy yields offered by more traditional bond portfolios. But Zahradnik warns, "The unconstrained bond category has become a catch-all." She stressed the importance of know what you're buying, and making sure it works with your objective.

"More than any other bond category, unconstrained bond is about selecting the best manager," adds Schenone. Make sure you understand how the funds are generating their returns and what strategy they employ. "It's about manager selection rather than just the category," she says. She suggests investors combine a more traditional bond strategy as ballast against equity-market risk with an unconstrained portfolio that can provide more appreciation and income potential.

Weigh Your Cash Options The panelists were asked if it's worth taking risk at the short-end of the yield curve with cash holdings. "Cash is dry powder," said Shepherd. He doesn't think it makes sense to take risk with this part of your bond holdings--even if you're likely earning a negative return after inflation. "Taking risk defeats the purpose."

Zahradnik suggests that the level of risk should depend on your objective for the cash. "Is this cash to pay your bills this month? Cash to pay your mortgage in six months? Cash to buy a home in two to three years?" She recommends tiering your cash holdings, which will allow you to still meet the needs for your cash but capture a bit of additional yield. "Just make sure you know what the funds own," she adds.