With cracks starting to show in the economy, financial advisers need to take a closer look at how much risk their bond funds are taking.
Core bond funds are climbing down the credit ladder to find income but losing some of their diversification benefits as a result.
The increase in lower-credit issues could leave investors in the lurch if stocks take a turn for the worse, experts warn.
“The big risk investors are ignoring in the search for yield is, their bond portfolios are taking on a higher correlation to the equity market,” said Fran Kinniry, principal of the Vanguard Investment Strategy Group.
The average intermediate-term-bond fund had just 47% of its assets invested in the highest-rated bonds at the end of December, down from 64% before the financial crisis, according to Morningstar Inc.
Bonds on the lowest end of the investment-grade spectrum have jumped to a 36% average weighting, from 22% five years ago.
TRIPLE-B
For example, the $2.2 billion ING Intermediate-Term Bond Fund (IPIIX), has a 29% allocation to BBB-rated bonds, the lowest level of investment-grade, and an 11% allocation to high-yield, or junk, bonds. The $1.7 billion Pioneer Bond Fund (PIOBX) has a 28% allocation to BBB-rated bonds and 19% in high-yield.
By comparison, the Barclays Aggregate Bond Index, the benchmark index for core bond funds, has a 68% weighting to the highest-rated debt and just 10% to lower BBB-rated investment-grade bonds. It has zero high-yield bonds.
“We're always looking for the best risk/return opportunities in the market,” said Matt Toms, head of US Taxable Fixed Income for ING U.S. Investment Management.
Because the Federal Reserve Bank is keeping interest rates suppressed through its bond-purchasing program, he favors taking on credit risk over interest rate risk.
“The low interest rates are pulling intermediate-term-bond funds away from as much of a high- quality Treasury bias and toward a more diversified mix of credit and interest rate risk,” Mr. Toms said.
"NEGATIVE CORRELATION'
The lower-rated credits tend to be more correlated to movements in the equity market. The highest-rated credits, typically Treasuries, have proved to be the only bonds that have consistently gone up when stocks have gone down.
“During the crisis and during shocks, the one thing that has negative correlation is Treasuries,” said Kathy Jones, a fixed-income strategist at The Charles Schwab Corp.
So far, the riskier bets have paid off for core bond funds.
In the first quarter, the Barclays Aggregate notched its first negative quarter in more than five years, yet the average core bond fund was up about 0.5%, according to Morningstar.
“The extra risk has provided significant outperformance, but what if the tide turns the other way?” asked John Flahive, director of fixed income -at BNY Mellon Wealth Management.
That is the $64,000 question. Will the managers be able to reduce risk in time if they see warning signs in the stock market?
History suggests that most won't be.
In 2008 and 2011, the average bond fund trailed the Barclays Aggregate because it was holding fewer Treasuries, which rallied when stocks went south.
The average intermediate-term-bond fund lost 4.7% in 2008, while the benchmark gained 5.24%. In 2011, the average bond fund gained 5.6%; the Barclays Aggregate gained 7.84%.
“We really worry that as people try to change their portfolio in quiet and very good times, the changes look like good decisions, but just because an allocation has not shown its risk doesn't mean it's not there,” Mr. Kinniry said. “We're not calling for a bear market, but bear markets do happen.”
SAFETY OR YIELD
The extra risk taking means that financial advisers not only have to be more aware of what their fund managers are buying but also why they are buying bonds in the first place: safety or yield.
“That's really up to the adviser,” said Jennifer Vail, head of fixed income at U.S. Bank Wealth Management.
Before the financial crisis, it was easy to find both in the same neat little package. Grabbing a 5% yield was as easy as buying a 10-year Treasury as recently as 2007.
Today, the 100 largest high-yield issuers don't yield much.
Charlie Smith, chief investment officer at advisory firm Fort Pitt Capital Group, is happy taking the extra income for now and is keeping a keen eye on high-yield-bond exchange-traded funds.
“Typically, the low-grade debt tends to lead equities. Those are the signs we're looking for,” he said.
As long as rates on Treasuries continue to flirt with record-high yields, expect bond funds to continue chasing yield.
“Fund managers are paid for performance,” Ms. Jones said.
jkephart@investmentnews.com Twitter: @jasonkephart
