Considerations for Today's Bond Investor

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. While investors have been fretting about rising yields for the better part of a decade, lately yields have been trending in the other direction. Joining me to share some perspective on this issue is Tom Lauricella. He is an editorial director at Morningstar.

Tom Lauricella: Glad to be here.

Benz: Tom, let's talk about declining yields, which we've seen so far in 2019. They tend to be good for bond prices, but for people who want to keep their money very safe in cash instruments, that means that they have to settle for lower yields, right?

Lauricella: Bonds makes for an interesting story in that you can have a good news, bad news situation at the exact same time. So, what we've seen this year is that bond prices have been rising but yields have been falling. So, the value of an investor's bond account maybe rising but the yields, the yields that they are earning, are actually dropping and for any money that they need to reinvest, they are going to be earning less money on that. So, it's this good news, bad news story for bond investors.

Benz: Let's talk about the factors that tend to drive yields down. It's generally when investors are thinking that the economy will weaken. What are sort of the forces that are pushing down on bond yields recently?

Lauricella: For bond investors, when you're thinking about what the dynamics of the market are, the story is that good news is bad news and bad news is good news. So, when the economy looks like it's weakening, if inflation looks like it's going to be declining, which comes along with a weakening economy, that's actually good news for bond prices but bad news in terms of the yields going down. When we have good news for the economy, things are getting stronger, it looks like inflation is going to rise, that's going to send bond prices down. So, it can be a little confusing. I mean, the bond markets are confusing. It can be hard to wrap your arms around at sometimes.

Benz: And so, for individual investors who have bond funds in their portfolios, I think there might be a temptation to think about, well, how should I play this? We've seen long-term bonds--when yields decline, long-term bonds perform really well. There might be a temptation to kind of load the boat with those bonds at this point. How should investors approach changes in interest rates whether up or down?

Lauricella: The first and easy answer is, you should have an asset allocation that works for longer than just a short-term market cycle. You want to have an asset allocation that matches up with your goals, whether they are long-term goals such as retirement or shorter-term goals in terms of saving money for an expense that you have in the next couple of years. So, really, it's: Set that asset allocation across the portfolio, stocks, bonds, what have you, and don't get too worked up about those short-term moves. If there's a move happening in the market, that potentially is extreme enough that it affects your ability to reach one of those goals, maybe then you can rethink how you approach your bond portfolio. But right now, we are not in much of an extreme actually when it comes to bond prices.

Benz: And the fact is, too, it seems like the bond market tends to price in this news really quickly. So, if you decide to sort of up-end your portfolio in search of whatever you think might happen, there's a good chance you might be late, right?

Lauricella: Oh, yeah. The bond market is like any other market. It's very, very difficult to time it. The big professional bond managers--it's not what they are trying to do. They are looking at longer-term trends. They are analyzing the trends behind the issuers, governments, or corporations, and they are not trying to time the market really--maybe just tweaks around the edges. Small investors, individual investors shouldn't try and do that either.

Benz: That's sort of how to approach thinking about the interest-rate sensitivity in your portfolio. Let's talk a little bit about credit sensitivity. Because it seems like if the market is concerned about a weakening economy, what should I be worried about in terms of sort of the complexion of my bond portfolio? Are there any types of bonds or bond funds that would tend to get hit particularly hard in a weakening economy?

Lauricella: I think credit quality is one of the least understood and least appreciated aspects of bond investing. Many investors I don't think quite realize that when they are holding a portfolio that has corporate bonds in it through a fund that invests in either investment-grade, very high-quality bonds, or junk bonds, low, there can be a lot of volatility in that part of the portfolio. It's not like a government bond where you are going to have changes based on interest rates, but credit quality is a whole another lever there. And we have seen time and time again where things like junk-bond funds or even shorter-term funds like bank-loan funds can be fairly volatile based on the credit quality. So, when we run into the times where the economy is looking just like it might fall into a recession such as happened in the fourth quarter of last year, you can see some real losses in credit funds. So, that happened in the fourth quarter. Junk bonds took a pretty big hit. Bank-loan funds took a pretty big hit. So, investors should keep an eye on that. But that should be factored into your initial asset-allocation strategy.

Benz: And you did a little bit of work on correlations among various bond types relative to stocks, and I worked on this recently, too. The idea is, if you want something that's going to give you a good ballast if you have an equity-heavy portfolio, it's generally not going to be that credit-sensitive stuff, right?

Lauricella: Right. High-yield bond funds track the stock market pretty closely--maybe not in terms of magnitude, but if you watch your high-yield bond funds, if the stock market goes down in value, your high-yield bond funds are probably also losing money. They are not great for adding diversification to a portfolio. It's a little less true for an investment-grade bond fund. They won't move as much up or down along with the stock market because there's more interest-rate sensitivity. But they are still not providing as much diversification to the portfolio as a government-bond fund will. Ultimately, if you want something that's going go the opposite direction as much as possible with stocks and really provide that short-term diversification, it's government-bond funds that will provide that lever.

Benz: Let's talk about stocks. In an era or in a period where investors seem worried about the strength of the economy, should investors be concerned about stocks if we are heading into sort of, if not a recession, then some sort of an economic slackening?

Lauricella: Well, again, I think it comes down to that asset-allocation question. Whenever an investor is setting that allocation, if it's in line with your long-term goals, you are going to allow for some of that flexibility over market cycles. So, particularly with a retirement portfolio, you are going to have a lot of ups and downs over that time. So, right now, the market seems to be going back and forth about the prospects for a recession. A lot of it's depending on how responsive people think the Federal Reserve will be in terms of helping the economy avoid recession. So, we're in a really tricky place right now. The valuations in the stock market, according to Morningstar research, were pretty much right there in the middle ...

Benz: Not cheap.

Lauricella: ...not cheap, not expensive. So, depending on a week, you can look one way or the other. But really, it's really just a matter of sticking to that long-term asset-allocation focus.

Benz: Tom, always great to get your perspective. Thank you so much for being here.

Lauricella: Glad to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.