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Investing Specialists

ETF Model Bucket Portfolios Get Fixed-Income Switch

We're using an active fund in our ETF portfolios. What gives?

One of the benefits of owning a portfolio that's composed of exchange-traded funds is that you shouldn't have to make significant changes, if any, especially if you've populated your portfolio with broad, low-cost index trackers. The ability to be hands-off is a key virtue for busy investors of all ages, but especially for retirees

I aim to take a similarly hands-off approach with my model portfolios. My assumption is that investors will do their own rebalancing to stay in sync with their asset-allocation frameworks. Thus, I'll make changes only if one of the holdings has experienced a substantive change. In the case of ETFs, that would be an expense-ratio change or a strategy shift that affects the underlying portfolio and how the fund fits into the portfolio overall.

I'll also make changes if holdings in the portfolio are no longer the top options in their Morningstar Categories--specifically, if our analysts downgrade a Morningstar Medalist fund to a Neutral or Negative rating. I'll put up with Neutral or nonrated funds in my portfolios geared toward specific fund families, where there may not be more than one choice in a crucial category. But given that my baseline mutual fund and ETF portfolios are meant to feature top funds of various types, my goal is to stick with medalists for these portfolios.

Owing to a ratings change, I recently removed  SPDR Blackstone/GSO Senior Loan (SRLN) from my Conservative and Moderate ETF portfolios. That fund was downgraded to Neutral from Bronze based on its mediocre performance and a process that doesn't stand out relative to its category peers. I replaced the fund with  Fidelity Floating Rate High Income (FFRHX), which is Bronze-rated. While the latter is not an ETF, there are currently no medalist ETFs in the bank-loan category. In a similar vein, there are no medalist high-yield bond ETFs, either, which is why I've employed  Vanguard High-Yield Corporate (VWEAX) in the high-yield slot in the ETF portfolios.

In the case of both portfolios, the position sizes are relatively small: 7.5% for the Moderate ETF portfolio and 6.0% for the Conservative ETF portfolio. The Aggressive ETF portfolio was unaffected by this change, because it doesn't include a bank-loan position. (The Aggressive ETF Bucket Portfolio is more equity-heavy; thus, its bond allocation contains fewer individual holdings.)

What the Heck Are Bank Loans?
Before getting into the specifics of the change, let's take a closer look at the bank-loan category. Bank loans--which may also be called "leveraged loans," or "floating-rate loans," or perhaps most aptly, "senior loans"--are loans that banks or other lenders extend to companies. These loans are backed by collateral, the company's assets. The "senior" part relates to the fact that if the company defaults, the lender is ahead of other creditors in its claim on the company's assets.

Bank-loan investments are often lumped together with high-yield bonds in asset-allocation discussions because the companies that borrow via the senior-loan market often have below-investment-grade ratings. Most bank-loan funds cluster in credits rated BB, B, and below B. The trade-off, of course, is that both high-yield bonds and bank loans are more sensitive to what's going on in the economy. The reason is straightforward: Investors reasonably assume that weak economic conditions will make it harder for low-quality borrowers to make good on their debts. In 2008, for example, the average high-yield bond fund in Morningstar's database lost 27%, while the average bank-loan fund shed 30% of its value. In 2018's fourth quarter, as jitters about a weakening economy roiled the stock market and high-quality bonds surged, the typical bank-loan fund in Morningstar's database lost 3.4%.

So, why monkey with bank loans, or high-yield bonds, for that matter? To be sure, I don't consider the bank-loan category a must-have; retired investors could reasonably stick with stocks, high-quality bonds, and a small cash stake to meet their spending needs and call it a day. (My "minimalist" bucket portfolios are geared toward investors who would like to do just that.)  But the ability to pick up a slightly higher yield is one attraction; bank-loan investments pay higher yields than high-quality bonds to compensate for their extra credit risk. Bank loans offer an additional feature that makes them attractive in periods of rising interest rates, rising inflation, or both. Specifically, the rates on these loans reset at regular intervals, in line with prevailing interest rates. That means that in contrast with other bonds, whose prices typically decline when yields trend up, bank-loan investments might even gain in such an environment. In the first quarter of 2018, for example, when interest-rate jitters spooked the bond and stock markets, the average bank-loan fund mustered a small gain.

The Case for a (More) Conservative Option
Some market watchers have recently been sounding alarm bells about the bank-loan market. A weakening economy would, of course, affect lower-rated credits as a group, including bank-loan investments and high-yield bonds. But critics are also concerned about the bank-loan market in particular, owing to concerns about liquidity, the issuance of bank loans with weak covenants (or lender protections), and an explosion of issuance overall. 

Against that backdrop, it makes sense for investors who own bank-loan investments to steer clear of the riskier entrants in the category, which typically offer tantalizing yields relative to their higher-quality, lower-risk counterparts. Fidelity Floating Rate High Income had historically been one of the most conservative options in the category, maintaining a high cash stake and shying away from the lowest-quality loans. Yet Morningstar senior analyst Eric Jacobson notes that the fund's risk profile isn't out of line with its peers these days; specifically, he says that manager Eric Mollenhauer has trimmed cash and increased its exposure to lower-quality credits such that the fund's credit-rating breakdown is now roughly in line with its average category peers. As further evidence that the fund has begun to take more risks, Jacobson points to the fact that its yield is now fairly close to the category average, whereas it was once notably lower. Nonetheless, he still considers it a solid moderate option, thanks largely to its competent management and strong research resources. 

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