For Bond Funds, Is Core-Plus Really a Minus?
This year's turbulent fixed-income market sheds some light on the limitations of intermediate core-plus bond funds.
If you're looking to fill out your portfolio's fixed-income sleeve, the intermediate core bond and intermediate core-plus bond Morningstar Categories are logical places to start. Both categories are home to funds that invest in a diversified mix of intermediate-maturity investment-grade U.S. bonds, including Treasuries, mortgage-backed securities, and corporate bonds. Thus, they afford investors exposure to a big swath of the U.S. bond market in one fell swoop, with core-plus funds going further afield than core funds into areas like high-yield bonds, bank loans, and foreign currencies. These funds have proved to be popular with investors; the two categories combined were home to nearly $1.7 trillion in assets as of March 31, 2020.
Similar but Different
While the two groups look similar on the surface, the recent market sell-off has brought some important differences into stark relief. In the first quarter of 2020, the average intermediate core bond fund gained 1.49%, whereas the typical intermediate core-plus bond fund lost 1.19%. Why the divergence? Investors fled lower-quality assets for the safety of Treasuries, which were by far the best-performing fixed-income sector for the quarter. Since core-plus bond funds by definition go beyond Treasuries, it means they held more of these lower-quality bonds than core bond funds did. Indeed, investment-grade corporates were down about 3.6% for the quarter, and high-yield corporates were down even more, with losses of 12.7%.
We can clearly see the relationship between first-quarter performance and credit quality in the chart below, which sorts funds in both the intermediate core and intermediate core-plus categories based on their average credit quality. Core-plus funds have shown similar patterns during previous downturns, such as the commodity and high-yield market sell-offs in the second half of 2015 and early 2016.
The Yield Advantage
Of course, there are some areas where the intermediate core-plus bond category has the edge. Income generation is one. The average intermediate core-plus fund paid out 2.77% in income over the trailing 12 months ended April 30, 2020, compared with 2.42% for the typical intermediate core fund. Thanks to widening credit spreads, this yield advantage looks even more compelling now. The average SEC yield--an annualized income figure based on distributions made over the past 30 days--for intermediate core-plus funds was 2.4% as of April 30, compared with just 1.9% for intermediate core funds.
This extra income has also translated into stronger long-term returns. Over the past 10 years, intermediate core-plus funds have generated annualized returns of 4.01%, compared with 3.57% for intermediate core funds. However, this return advantage has also brought higher risk, as this year's losses for intermediate core-plus funds attest.
Role in Portfolio
Because of their exposure to riskier corners of the fixed-income market, intermediate core-plus bond funds also don't excel as portfolio diversifiers. Over the past three years, the category has shown a stronger correlation with equity market benchmarks than other fixed-income categories, such as intermediate core bond and government bond. Indeed, the average intermediate core-plus fund has a correlation of 0.36 with the S&P 500, compared with just 0.12 for the intermediate core category. When the going gets tough in equities, intermediate core-plus funds are likely to feel pain at the same time. While some investors might be able to tolerate this trade-off in exchange for extra yield, it's important to keep the downside in mind.
From a portfolio construction standpoint, a key question is what role you want your fixed-income holdings to play. If you're looking for a buffer against volatility in down markets, other fixed-income categories are better suited for that role. The intermediate core bond category has a number of strong performers, such as Morningstar Medalists Vanguard Total Bond Market Index (VBMFX), Fidelity U.S. Bond Index (FXNAX), and Baird Aggregate Bond (BAGSX). High-quality municipal-bond funds can also make sense for the taxable portion of a portfolio, particularly now that taxable-equivalent yields have edged up from earlier this year. From a diversification perspective, intermediate and long-term Treasuries are the most effective way to offset equity risk, although their rock-bottom yields may lead to lower returns going forward. If you're approaching retirement or already in retirement, you'll probably want to include some Treasury Inflation-Protected Securities exposure to help offset the risk of future inflation.
If you're looking for higher yield and long-term returns, an intermediate core-plus bond fund can fill a legitimate role in your portfolio. But as this year's performance illustrates, it's important to understand the trade-offs--and make sure you're willing to tolerate occasional losses when riskier fixed-income assets are out of favor.
Amy C. Arnott has a position in the following securities mentioned above: VBMFX. Find out about Morningstar’s editorial policies.
Transparency is how we protect the integrity of our work and keep empowering investors to achieve their goals and dreams. And we have unwavering standards for how we keep that integrity intact, from our research and data to our policies on content and your personal data.
We’d like to share more about how we work and what drives our day-to-day business.
We sell different types of products and services to both investment professionals and individual investors. These products and services are usually sold through license agreements or subscriptions. Our investment management business generates asset-based fees, which are calculated as a percentage of assets under management. We also sell both admissions and sponsorship packages for our investment conferences and advertising on our websites and newsletters.
How we use your information depends on the product and service that you use and your relationship with us. We may use it to:
To learn more about how we handle and protect your data, visit our privacy center.
Maintaining independence and editorial freedom is essential to our mission of empowering investor success. We provide a platform for our authors to report on investments fairly, accurately, and from the investor’s point of view. We also respect individual opinions––they represent the unvarnished thinking of our people and exacting analysis of our research processes. Our authors can publish views that we may or may not agree with, but they show their work, distinguish facts from opinions, and make sure their analysis is clear and in no way misleading or deceptive.
To further protect the integrity of our editorial content, we keep a strict separation between our sales teams and authors to remove any pressure or influence on our analyses and research.
Read our editorial policy to learn more about our process.