12 Charts on Morningstar's New U.S. Core Bond Categories

This article originally appeared in Morningstar Direct Cloud and Morningstar Office Cloud.

At the beginning of May, we rolled out two new bond Morningstar Categories, splitting up the intermediate-bond category--the largest fund category by assets--into intermediate core bond and intermediate core-plus bond. As the "core" element of their names suggests, these funds often act as the foundation for investors' fixed-income portfolios.

In this Q&A, Sarah Bush, director of fixed-income strategies for Morningstar Manager Research, explains the rationale behind creating the new categories as well as the differences between the two. In this piece, we'll take a closer look inside the intermediate core bond and intermediate core-plus bond categories. In the process, we'll put to work the new fixed-income data points available on Morningstar Direct Cloud.

As Bush notes, the categories have many similarities, but among the key differences is that intermediate core-plus bond strategies tend to have portfolios with a greater amount of lower-quality credit.

The following chart is based on Morningstar's new "calculated credit quality" data point.

Intermediate core bond strategies have a clear bias toward AAA rated debt, which constitutes an average of 57% of their portfolios. Intermediate core-plus bond funds, meanwhile, average about 45% in AAA debt. At the same time, core-plus funds hold an average of 19% in BBB rated debt, compared with less than 15% for core funds.

Non-U.S. debt and emerging-markets debt asset allocations can be a differentiator between funds in the two categories. For emerging-markets bonds, the averages aren't that different--3.2% for core plus and 1.3% for core—but the upper end of the ranges when it comes to weightings of emerging-markets bond holdings reflects the contrast. The following chart shows the average weighting, plus the average for those in the top half of the group and in the top quartile.

Duration, of course, is one of the key determinants in a bond fund's performance. But because the core and core-plus categories were carved out of the intermediate-bond category, the differences between the two are on average not as significant, although individual funds may diverge based on their particular strategy. The following chart is based on Morningstar's new "calculated effective duration" data available on Morningstar Direct Cloud.

These portfolio allocation differences manifest in correlation differences between the two categories.

Source: Morningstar.

The intermediate core bond category is correlated more highly to the Bloomberg Barclays U.S. Aggregate Bond Index, which tends to be more interest-rate-sensitive. However, intermediate core-plus bond funds tend to be more highly correlated to riskier benchmarks, such as high-yield bonds, emerging-markets bonds, and stocks.

Correlations play out most visibly during times of market turmoil. Not surprisingly, intermediate core-plus bond funds tend to perform worse during periods of credit stress. But when the markets are hit with rounds of interest-rate increases from the Federal Reserve--or simply expectations for tighter monetary policy, the landscape shifts.

The following chart looks at three different market shocks. The so-called taper tantrum of May through August 2013--when both credit and rate-sensitive markets fell sharply after chairman Ben Bernanke signaled that the Fed would be begin to taper off its quantitative easing policies set during the financial crisis; the commodity and high-yield market sell-offs that lasted from June 2015 through February 2016; and the period of Fed rate increases from August 2016 through December 2016.

The two most recent quarters provide another window into the performance characteristics of the two categories. During the fourth quarter of 2018, credit markets collapsed amid fears that Fed tightening would send the U.S. economy into a recession. Credit whipsawed back in the first quarter of 2019 as the Fed signaled it would hold off raising interest rates, a move that was also accompanied by a relatively smaller rally in more interest-rate-sensitive bonds.

With the following series of charts, we'll map credit quality--as measured by percentage of a portfolio that's below-investment-grade--against performance.

In the fourth quarter, the performance bias was clearly in favor of higher-quality portfolios and intermediate core bond strategies in general.

Source: Morningstar.

Then in the first quarter the tables turned dramatically.

Source: Morningstar.

From a longer-term perspective, it's a closer call, but the bias is toward lower credit quality.

Source: Morningstar.

The other takeaway is the wide variation in performance among intermediate core-plus bond funds throughout all three charts. The group's tilt-toward more wide-ranging strategies also produces a greater variety in outcomes.

The intermediate core bond category is dominated by the largest fund companies, especially Vanguard. Of the assets in the 10 largest core funds, Vanguard accounts for roughly half. Meanwhile, eight of the 10 largest funds carry Morningstar Analyst Ratings of Bronze of higher.

Source: Morningstar.

The largest intermediate core-plus bond funds, however, are from a more diverse array of managers, though largely still household names. On balance, performance among the largest intermediate core-plus bond funds has outpaced those in the intermediate core bond category, in large part reflecting the outperformance of credit over the last five years.

Source: Morningstar.

Among intermediate core-plus bond funds that have an Analyst Rating, AB Income ACGYX is a top performer. Morningstar senior analyst Emory Zink described the Bronze-rated fund as "adventurous," with 35% of the portfolio in high yield and emerging markets, complemented by currency bets.

Gold-rated Western Asset Core Plus Bond WACPX is the largest intermediate core-plus bond fund among the top performers, and its portfolio is reflective of the core-plus category's profile. It holds north of 7% of its portfolio in emerging-markets debt. Its duration is above average for the category at six years, as measured by Morningstar's calculated effective duration data point. While its long-term record ranks it toward the top, it also took a significant hit during the fourth-quarter 2018 sell-off.

Source: Morningstar.

In the intermediate core bond category, another Western Asset fund claims the top spot for the past five years: Gold-rated Western Asset Core Bond WATFX.

Baird Aggregate Bond BAGIX is another winner. The fund's rating was recently upgraded to Gold from Silver, owing to its "cohesive team, proven and deliberative process, and low fees," according to Morningstar analyst Alaina Bompiedi. The fund has had a bit of a tailwind in that it tends to hold greater weightings in lower-quality credit than other intermediate core bond funds. For example, Morningstar's calculated credit quality data show the fund has a 28% weighting in debt with a BBB rating, double the average for the group. One of its portfolio managers, Mary Ellen Stanek, was this year one of five nominees for Morningstar outstanding portfolio manager.