Market Turmoil Has Bent Bond Mutual Funds, but Most Have Not Broken

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Summary

• Many bond funds have suffered surprising losses in the recent market turmoil, prompting some investors to redeem.
• Liquidity strains have had an impact on all parts of the bond market, but an unprecedented response by the Federal Reserve and other policymakers should provide much-needed support to the higher-quality segments of the bond market.
• Trouble is most likely to hit funds that employ the most aggressive, yield-seeking strategies in their respective peer groups.
• Bond funds that earn Morningstar Analyst Ratings of Gold, Silver, and Bronze should be well-positioned to get through this tough stretch and take advantage of historic opportunities along the way.

Trying Times Plunging prices across bond sectors and even unheard-of liquidity strain in U.S. Treasury markets have rattled bond-fund investors' nerves in recent weeks. For those following the bond market news closely, reports of liquidity stress are everywhere. Leveraged investors--from hedge funds to REITs--have been forced to unwind trades, dealer trading desks are operating at a reduced capacity as a result of shelter-at-home policies, bond exchange-traded funds have traded at discounts to their net asset value, and redemptions have even been suspended on a group of Nordic corporate bond funds.

Anxious fund investors, meanwhile, have pulled their money out of the bond market’s most economically sensitive sectors, such as high-yield corporate, bank-loan, and high-yield municipal funds--but even higher-quality categories as well, including the intermediate core and core-plus bond, short-term, and ultrashort bond Morningstar Categories. Typically positioned by asset managers to be the safer investments in bond-land, the ultrashort bond and short-term bond categories have respectively lost 3.3% and 5.5% so far this month through March 24. That’s not dreadful considering the S&P 500 lost close to 30%, but the worst performers in these categories have shed double digits, unquestionably a disappointing outcome for investors who would have reasonably expected these funds do a better job protecting their capital.

The Good News Reminiscent of the financial crisis, those losses have mostly been the result of extreme market dislocations rather than underlying defaults, even in high-quality sectors. The Bloomberg Barclays U.S. Aggregate Bond Index, a common benchmark for U.S. investment-grade-focused bond funds, lost 2.3% for the month through March 24. While the index's exposure to U.S. Treasuries has seen gains, its investment-grade corporate bonds have experienced steep declines of 12.3%, on average, over this period. For context, the worst calendar month ever endured by the ICE BofA Corporate Bond Index--going back into the early 1970s--produced a 7.4% loss. Falling prices have inflicted pain on short-dated investment-grade corporates, too: Corporate bond maturities of less than three years have lost close to 4% on average for the month so far. The index's floating-rate asset-backed securities holdings have similarly lost around 3.5%. Losses in these latter two sectors help explain why even risk-conscious short-term bond funds have struggled.

The good news for bond investors is that much of the investment-grade bond market is now trading at historically cheap prices. The additional yield over Treasuries offered by investment-grade corporate debt (between 300 and 400 basis points depending on your source) has reached levels not seen since a few months into 2009’s market recovery. Unlike the high-yield corporate market’s most leveraged junk-rated issuers, the majority of these companies aren’t at risk of defaulting on their bond payments, even in a sharp economic contraction. And yet, investors are getting paid as much to own investment-grade corporates today as they were to own high-yield corporates at the beginning of the year. Similarly, AAA rated ABS credit card and auto-loan receivables are structured to withstand a severe economic downturn without experiencing impairment, and those bonds are also trading at historically cheap prices. The same is generally true for the highest-quality tranches of some out-of-index sectors such as collateralized loan obligations and commercial mortgage-backed securities, though those aren't homogenous groups.

Meanwhile, regulators across the spectrum have stepped up in unison to right the ship. Above all, the Federal Reserve has taken swift, unprecedented steps to reassure and support markets. In particular, the central bank has signaled that there is no limit to the amount of dollars it will create to shore up the financial system. And while less well-advertised, they have dramatically expanded so-called swap lines with other central banks around the world to help stabilize the global financial system.

On a more market-specific level, the Fed has revived or implemented other programs such as the Money Market Fund Liquidity Facility. The regulator has also reportedly signaled to banks--which have dramatically tamped down their own risk-taking since the financial crisis--that it's comfortable with them taking on more balance-sheet risk to support markets. The SEC has stepped up as well, releasing an order on Monday effectively suspending certain rules that otherwise block asset managers or their affiliates from lending to their funds. That now gives mutual funds the flexibility to turn to their management companies for loans to provide liquidity should they face pressure to sell less-liquid assets to meet redemptions.

Even with those efforts, markets have craved action to support the underlying economy; Congress answered that call by reaching a preliminary agreement on Tuesday to pump out $2 trillion of fiscal spending.

While some of these measures will take time to ramp up, there are already signs that they're working. As my colleague Ben Johnson noted, discounts disappeared on some higher-quality bond ETFs after the Federal Reserve announced it would purchase ETFs, and trading conditions appear to be improving in the agency mortgage, investment-grade corporate, and muni bond sectors.

The Bad News Unfortunately, some bond funds are more vulnerable than others in a liquidity crunch. As yields on high-quality bonds have near historic lows for years following the global financial crisis, some fund managers were tempted to reach for yield by venturing into riskier, less liquid segments of the market. One area where they found it was in niche structured credit sectors, particularly subordinated tranches of securitized bonds that rank below those that have a senior claim on underlying assets' cash flows. These much-riskier securities are difficult to identify--and distinguish from their higher-quality brethren--in public portfolio disclosures, and unlike corporate bonds and high-quality asset-backed sectors, their performance isn't tracked by widely followed indexes. Although these sectors have rewarded investors with generous payouts in recent years, they've suffered spiraling price declines.

Among the more popular of these higher-yielding structured sectors in recent years have been agency credit risk transfer securities, or CRTs, a sector created in 2013 to transfer mortgage credit risk from government mortgage agency balance sheets to private investors. While these bonds differ in the degree of credit risk they take on, they hadn’t as a group had to endure extreme market illiquidity or an economic slowdown--until now. Concerns about the impact of mortgage payment holidays--which would provide relief to struggling homeowners grappling with coronavirus-related hardship--on CRT fundamentals, in addition to forced selling from leveraged investors and funds, have caused prices on the sector to plunge. Some of these bonds are reportedly trading at prices 40 percentage points lower than their highs, with yield spreads widening to previously unseen levels of more than 2,000 basis points. As we saw during the financial crisis, even some bonds that ultimately made good on their principal and interest payments--as some of these still may--suffered dramatic price declines from which it took years to recover.

While subordinated tranches in other structured credit sectors--such as collateralized loan obligations, nonagency residential and commercial mortgages, and other asset-backed securitizations--are similarly vulnerable in this environment, it’s rare to see open-end mutual funds invest in their lower-rated, subordinated tranches given that their inordinate credit and liquidity risk make for a potentially combustible package inside a daily liquidity vehicle. CRTs have more commonly appeared in mutual fund portfolios but usually only in small sizes of 10% or less, while some large, active, diversified bond managers such as Dodge & Cox, Fidelity, Pimco, and TCW have steered clear. Outside of those with modest CRT stakes, Morningstar analysts have been reluctant to award ratings of Gold, Silver, or Bronze to diversified bond funds that invest in these riskier corners of the structured credit market.

That’s especially true for funds we’ve rated in the ultrashort and short-term bond categories, where investors who are enticed by funds that offer a little bit of extra yield in the good years are also quick to run when those funds fail to meet their expectations for safety. Those hit hardest in the current crisis tend to have larger exposures to various flavors of structured credit. For instance, Neutral-rated Invesco Variable Rate Investment Grade ETF VRIG, which is the ultrashort category’s second-worst performer so far in March with an 11.5% loss, has held more than 20% in CRTs for the past few years. As of December 2019, the fund’s liquidity buffer in the form of a U.S. Treasury stake was a modest 10% of assets.

The most vulnerable strategies in the current environment have been flashing red well in advance. For example, AlphaCentric Income Opportunities IOFIX, a multisector bond fund that has invested the majority of its assets in mezzanine subprime MBS, has experienced heavy redemptions in recent weeks. Given that the portfolio was roughly 95% invested in nonagency residential mortgage credit, it’s highly unlikely the managers were able to raise cash to meet those redemptions without locking in losses in the current environment. The fund has erased more than 40% of its value for its shareholders since the beginning of March, with most of those losses coming in the last several trading days.

But that fund’s highly aggressive approach already made it an outlier relative to competitors in the multisector bond category, which is home to funds with a greater appetite for credit-sensitive sectors. Its portfolio chock-full of subordinated mortgage credit avoided by other fund managers, its indeterminate credit quality profile (most of the fund’s holdings were nonrated), and absence of high-quality holdings to provide liquidity should have raised concerns for any investor. The fund’s chart-topping returns in recent years--its trailing three-year annualized return of 10.4% through February 2020 outpaced its next closest competitors’ by a full 300 basis points--should have also raised questions about the risks its managers were taking to achieve those results.

Today's Pain May Well Have Planted the Seeds of Recovery The moral of the story isn't much different than it's ever been. When a yield- and return-chasing strategy that digs deep into sectors with lots of credit and liquidity risk meets investors who crave that income so much that they're willing to ignore its risks, you wind up with an inherently unstable pairing. As we've just seen, many of those same investors are easily spooked enough to ask for their money back the minute trouble hits, forcing managers to dump riskier holdings at the worst possible time.

On the other hand, the historic bargains currently available in investment-grade bond sectors give investors who own well-diversified intermediate core and core-plus bond funds plenty of reason to hold on to their investments. When regulators and lawmakers step in to repair markets, they look to first protect sectors that are being hurt for technical rather than fundamental reasons, all but ensuring that high-quality securities will be money-good when all is said and done. Meanwhile, diversified bond funds that earn Gold, Silver, and Bronze ratings almost all have ample liquidity in the form of U.S. Treasury and agency MBS holdings to be able to meet redemptions and reposition their portfolios to take advantage of bargains in other sectors. In fact, many are have already started.

Editor's Note: This article was updated to correct a reference to collateralized loan obligations.