A Risk Drill for Your Bond Holdings

Note: This article is part of Morningstar's May 2016 Risk Management Boot Camp special report.

Over the past decade and a half, the Barclays Aggregate Bond Index has been just one fourth as volatile as the U.S. equity market, as measured by standard deviation.

That's not to say that bonds don't court some risks, however. Investors venturing into lower-quality bonds can suffer punishing losses during economic shocks, when such credits often tumble due to worries about whether issuers will be able to make good on their obligations. And in recent years, the main preoccupation for many bond investors has been the possibility of higher interest rates, which spell trouble for bond prices.

As you survey your bond holdings today, here are some of the key questions to focus on, as well as details on how to find the answers.

Question 1: How interest-rate sensitive is the portfolio?

Yes, rising interest rates can be welcome, particularly for today's yield-starved retirees. But when new, higher-yielding bonds hit the market, that hurts the prices of already existing bonds with lower yields attached to them. The longer the duration of a bond portfolio, the more vulnerable it will tend to be to interest rate increases. That's because not only will investors in the long-duration bond be stuck holding a lower-yielding asset when rates increase, but they will be forced to hold on to it for a longer period of time, increasing their opportunity cost. Investors can mitigate interest-rate risk somewhat by holding individual bonds until maturity, but it can be difficult for smaller investors to build well-diversified portfolios composed of individual bonds. (

discusses why investing in individual bonds carries more risk than it might first appear.) Moreover, even if they buy and hold a bond, they'll still face opportunity cost if rates trend up.

discusses a stress test you can use how to use duration to help assess how much interest-rate sensitivity is embedded in your bond funds. Investors can also reasonably match bonds' durations to their time horizons. For example,

Question 2: How vulnerable is the portfolio to an economic downturn and the stock market?

Another key risk factor for bonds is credit risk--the possibility that a bond issuer will be unable to pay its debts. To help make up for this risk, bond issuers with lower credit qualities typically must pay their bondholders higher yields than high-quality firms issuing bonds of the same duration. Default risk isn't the only reason that holders of lower-quality credits can run into trouble: In periods of economic hardship, such as the 2008 financial crisis, investors often sell out of low-quality bonds pre-emptively, thereby depressing their prices. That makes lower-quality bonds and bond funds less-than-ideal diversifiers for investors' equity holdings, in that their performance will often be directionally similar to stocks.

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Morningstar's Credit Quality breakdowns, found on the Portfolio tab for bond funds, depict the percentage a fund holds in each of the credit-quality rungs, alongside the weightings for a like-minded benchmark and category average. Anything rated BB or below is considered below investment grade, or "junk." Funds in Morningstar's short-, intermediate-, and long-term bond funds categories are typically prohibited by charter from having a large share of their portfolios in junk bonds; 15% is a common upper limit. Meanwhile, bond funds in more specialized categories frequently have junky portfolios; that group includes high-yield bond funds, bank-loan (or floating-rate) funds, and multisector bond funds. as well as multisector and bank-loan funds. Some nontraditional bond funds also have lower-quality complexions; the average such fund recently had 34% in bonds rated BB and another 7% in nonrated bonds. (Nonrated bonds are often of lower quality.)

Question 3: How big a risk is inflation?

Investors earning a fixed yield on their bond investments will see a decline in their real, take-home yields (that is, their purchasing power from that bond investment) as inflation increases. Because most bonds are vulnerable to inflation risk, investors drawing upon their bond portfolios for living expenses should take care to add inflation protection to their toolkits. (Inflation protection is less important for investors who aren't in drawdown mode, as discussed

.)

Treasury Inflation-Protected Securities and I-bonds are the most direct hedge against inflation: They include an inflation adjustment on top of the yields the bonds offer, thereby effectively removing this risk for bondholders. Bank loans, or floating rate loans, also tend to behave well in periods when costs are on the move, in that their yields adjust upward to keep pace with prevailing yields.

Question 4: Does the portfolio hold a lot of illiquid bonds that could be difficult to sell in a pinch?

The market for U.S. Treasury bonds is the most liquid in the world. The market for some other bonds? Not so much. Liquidity risk--the chance that an investor would want or need to sell a bond but find no ready buyers--came to the fore in late 2015.

Director of fixed income manager research Sarah Bush discussed liquidity risk in

. In general, it tends to be a bigger risk for categories like high-yield and bank loans and less problematic for funds with the bulk of their assets in high-quality bonds.

Question 5: Is currency risk in the mix?

Holders of foreign bonds face all of the same risks outlined above, but they may also face a few additional risk factors. One of the most notable is currency risk--the chance that the currency in which the bond is denominated falls relative to the investor's home currency, thereby reducing or even wiping out any appreciation from the bond itself over the investor's holding period. Some foreign-bond funds hedge their currency exposures to effectively wipe out the effects of currency fluctuations on returns, thereby reducing volatility and making returns more bondlike. Others explicitly focus on bonds denominated in foreign currencies.

This is obviously a bigger risk factor for investors in world-bond and emerging-markets bond funds than domestically focused bond funds. Yet some core-type funds dabble in foreign currencies, as do some multisector bond funds. If foreign-currency exposure is or has been part of a fund's strategy, Morningstar's analysts will usually mention it in their Analyst Reports.