A version of this article was published in the November 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.
Funds that take on elevated credit risk are prone to unhappy surprises for investors. For some strategies, an aggressive credit posture relative to peers may be the norm, for others it may be a sign of stretching for yield. While a strategy's credit-quality profile in isolation is helpful, it's also important to consider which bond sectors the fund is taking credit risk in. Morningstar's Fixed Income Exposure Analysis, or FIEA (which can be found on Morningstar.com and Morningstar Direct Cloud), is a particularly helpful tool for this as it uses holdings-based analysis to provide an indication of a fund's credit-quality breakdown by sector.
It is also worth considering the amount of credit risk a strategy is taking on relative to where credit spreads currently stand. For instance, while U.S. corporate high-yield spreads have widened in November 2021, they still aren't too far from all-time tight levels.
With all that in mind, here's a deeper dive into four funds that currently hold elevated stakes in junk-rated debt relative to their Morningstar Category peers.
Fidelity Strategic Income FADMX, which earns a Morningstar Analyst Rating of Silver, held 50% of assets in below-investment-grade fare and a further 12% in nonrated bonds as of September 2021. Both stakes ranked above the multisector bond category norm of 38% in high-yield debt and 8% in nonrated fare. Looking at the FIEA credit-quality breakdown by sector provides an indication of where this multisector bond fund is taking on credit risk, and as of June, the bulk of its high-yield exposure was composed of corporates. That said, this strategy has historically had success holding an aggressive credit stance relative to peers, and it's also worth noting that the bulk of its junk-bond stake was in the top two high-yield notches, BB and B.
Neutral-rated JPMorgan Income JMSIX also dwells in the multisector bond category and adopts a very flexible approach in its hunt for income. As of September 2021, it held a total of 58% of assets in below-investment-grade and nonrated fare. That's not out of the ordinary for this strategy, though its roughly 20% stake in bonds that are rated below B or unrated was elevated relative to its posture since 2017 and the category norm. The FIEA tool indicates that its below B and nonrated stake was largely composed of asset-backed and commercial mortgage-backed securities, while its BB and B rated exposure was mostly in corporate bonds. While the strategy's risk-taking has paid off since its 2014 inception, it has done so with above-average volatility and has experienced mixed results in market downturns.
Calvert Income CINCX, which receives a Neutral rating, resides in the corporate-bond category but adopts an environmental, social, and governance focus and casts a wider net than its mostly investment-grade-focused peer group. It does so by venturing into high-yield corporates and securitized credit, though that tack has produced mixed results over the long haul. As of September 2021, the strategy held 25% of assets in below-investment-grade credit, which was over 4 times the category norm. That allocation also ranked above the strategy's average in recent years: From January 2015 through June 2021, this offering averaged 18% in junk-rated debt. The FIEA breakdown shows that the majority of its high-yield stake was in corporate credit. However, it is worth considering that roughly four fifths of its junk-rated allocation was just one notch below investment grade in BB rated fare.
Bronze-rated TCW Total Return Bond TGLMX lands in the intermediate core-plus bond category, but it is a niche mortgage-focused strategy relative to more wide-ranging peers. As of September 2021, it held 17% of assets in junk-rated debt. While its high-yield stake was only modestly higher than the peer group norm, it held 14% in debt rated CCC and below, and its typical category peer had just 1% in that space. However, that wasn't too out of the ordinary for this strategy, as it averaged 11% in debt rated below B from January 2015 through June 2021. In addition, consistent with its focus area, the FIEA tool indicates that all its high-yield exposure was in securitized debt. Historically, nonagency residential mortgage-backed securities have constituted the vast majority of this strategy's below B stake, and its managers' disciplined approach has delivered strong risk-adjusted results over the long haul.
All told, an elevated allocation to below-investment-grade debt can be a cause for concern, but it depends on a number of factors, including where the strategy's stake ranks relative to its peers and its own historical profile, which sectors the allocation is in, and where valuations stand. When selecting a fund, be sure to look under the hood to avoid an unexpected surprise.