Handle These Bond Categories With Care

It’s unlikely the next big bear market for bonds will resemble the 2008 financial crisis. But it’s far enough back in the rearview mirror that the risks of forgetting its lessons are arguably crystallizing. Look at asset flows into some of the Morningstar Categories most badly burned during the crisis, combined with the fact that bonds have essentially been on one very long bull-market run. Yields are so low, and credit-sensitive debt arguably so richly priced, that even if Treasury rates remain stable and low, economic trouble has plenty of potential to hurt riskier bonds.

Each of the following categories has an unusual factor or feature, but they all share the commonality of having some of the largest drawdowns during the financial crisis, taking a long time to recover, and having positive inflows thus far in 2019 and strong flows overall during the past five years.

U.S. Corporate Bond. More than 30 of the funds in today's universe were around during the crisis as members of broader categories, and they didn't fare well. On average they plunged more than 15% during the crisis from peak to trough. The good news for those who stuck it out was that the extraordinary measures taken by the Fed and U.S. Treasury sparked a snap-back rally beginning in early 2009, and the category took only eight months to recover. It's difficult to imagine a scenario short of borderline Armageddon that would trigger a rerun of government help from that era. Meanwhile, investors have poured nearly $20 billion into the category over the past five years. And even though valuations have backed up some since they touched long-term lows in early 2018, they're still historically tight, particularly given developing worries over the economy.

High Yield Muni. The experience of this category during the financial crisis was one of the market's most painful because high-yield municipals took hits from two sides: They were almost a sure bet to feel pain when credit fears seized markets and liquidity dried up given their fundamentally risky nature, but the muni universe as a whole was slammed during the crisis--including its highest-quality debt--because so many investors (mostly via hedge funds) had used them to make huge leveraged bets that blew up and dragged the sector down. This category averaged a 29% loss during its worst stretch of the crisis and took a whopping 20 months to recover from its lows. Investors poured nearly $10 billion into the group during the first six months of 2019, though, and more than $30 billion since the start of 2014, when the category held less than $50 billion. Lower-quality municipals aren't always as economically sensitive as their taxable counterparts, but market crises that drain liquidity can be just as dangerous for them.

Multisector Bond. This category was among the worst hit during the crisis given the tendency of its funds to take more risk than core funds do in the pursuit of bigger yields and returns. So, when liquidity dried up, particularly among high-yield and emerging-markets sectors, this group took it on the chin. The category averaged a 19% drawdown, and even with the 2009 rally, it took nearly a year to recover. The fact that investors have been pouring money into the group over the past five years is reason for pause, though the action has been pretty concentrated, with PIMCO Income PIMIX taking a huge share of the category's flows. Even so, there's plenty of reason to believe that many of its newest clients--who anecdotally have often shifted from lower-risk categories--are themselves chasing yield and returns without enough fear of risk.