Uncover the hidden risks in your fixed income portfolio allocation

September 9, 2019

 

What’s in a name?

Actually not a whole lot when it comes to "core" bond investing. Advisors today are asked to navigate a market place of more than 400 mutual funds representing well in excess of $1 trillion in assets under management in the broad arena of "core," "core plus," "multisector," and "nontraditional" bond funds. While most of these strategies are often positioned as the centerpiece of a client's portfolio their design, risk exposures, performance, and ultimately their "investor suitability" are incredibly varied and require a deep understanding of the many different flavors of mutual funds out there.

Are the bond funds being used in your clients' portfolios as forthcoming as they could be about the risks they take? Some typical risks to evaluate include credit, liquidity, interest rate, and leverage. These risks take on great importance when looking under the hood of many active bond funds.

The uncertainty advantage

Slowing economic growth along with a troubling yield curve inversion are causing financial markets to be unsettled. In times of such market uncertainty, you may look for your clients' core bond allocation to act as a portfolio stabilizer.

Vanguard’s view on the markets:

  • There's a 40% chance of recession in the next 12–18 months.
  • The Federal Reserve has already cut rates once in 2019 and is likely to again.
  • Central bankers may face difficulty achieving their 2% annual inflation target.

Know what your clients own so they aren't vulnerable

Some of the largest and most popular bond funds may give the appearance of a core strategy, but in reality fall into one of the other Morningstar bond categories. This is why it's important to understand your bond allocation's underlying strategy and risk guardrails, so that you can anticipate how your clients' core allocation may behave in different market environments.

Morningstar recently divided their largest category, intermediate-term bond, into two new fund categories: intermediate core bond and intermediate core-plus bond. This division allows investors to better understand the risk and return expectations of funds in these respective categories. Further along the risk spectrum, bond-fund categories such as multisector and nontraditional typically have higher return targets, which require greater exposure to more volatile risk factors.

Let's take a closer look at these Morningstar categories which are home to some of the largest and highest profile active bond funds.

Morningstar bond categories Funds AUM Description
Intermediate core 142 $885B
  • Invest primarily in investment-grade U.S. fixed income issues including government, corporate, and securitized debt.
  • Hold less than 5% in below-investment-grade exposures.
Intermediate core-plus 178 $714B
  • Invest primarily in investment-grade U.S. fixed income issues including government, corporate, and securitized debt.
  • Have greater flexibility than core offerings to hold noncore sectors such as corporate high-yield, bank loan, emerging markets debt, and non-U.S. currency exposures.
Multisector 96 $255B
  • Seek income by diversifying their assets among several fixed-income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds, and high-yield U.S. debt securities.
  • Typically hold 35% to 65% of their assets in securities that are not rated or are rated BB and below by a major agency such as Standard & Poor's or Moody's Investors Service.
Nontraditional 90 $121B
  • Seek returns uncorrelated with those of the overall bond market.
  • Have the flexibility to invest tactically across a wide swath of individual sectors, including high-yield and foreign debt, in addition to the potential for significant usage of derivatives.

Being "true-to-label" in the core of clients' portfolios is key

With market uncertainty ruling the day, clients may be looking to bonds to offer some protection from volatility in a portfolio that only holds stocks. Historically, the returns of stocks and bonds have not been correlated. Understanding how bond funds perform relative to equities is key to ensuring your clients are getting their intended risk exposures. If the returns of bond funds are highly correlated with those of equities, then it illustrates the need to look deeper.

Ten-year return correlation of Morningstar bond categories with the S&P 500 Index

S&P 500 Index1.00
U.S. High-Yield Bond0.72
U.S. Nontraditional Bond0.50
U.S. Multisector Bond0.56
U.S. Intermediate Core-Plus Bond0.15
U.S. Intermediate Core Bond–0.03

Sources: Vanguard and Morningstar, Inc. as of July 31, 2019.

Bond funds should behave like bond funds

The three hypothetical scenarios in the figure below show the performance of Vanguard Core Bond Fund Admiral™ Shares (VCOBX) against the average returns of the Morningstar categories during periods of high market stress. These types of volatile markets push the stabilizing effects of core bonds front and center.

As you can see, VCOBX and the core category behaved as one might expect, whereas multisector and nontraditional segments, in particular, demonstrated return profiles more closely correlated with those of equities. Because these segments can veer into more risky assets and lower credit quality, it's critical to "know what you own" to ensure client portfolios are properly positioned for a potential market downturn.

When markets are volatile, how might your clients' bond funds behave?

When markets are volatile, how might your clients’ bond funds behave?

Note: These scenarios were calculated by taking the simple average of outcomes based on an equally weighted average of every fund in the category.

Source: Vanguard Advisor Portfolio Analytics and Consulting® and Bloomberg Risk Model as of July 31, 2019.

Identifying risk areas in clients’ strategic bond allocations

It's important to consider how an allocation to some of these noncore mandates is funded. If coming from the bond allocation of the portfolio, you may be losing some of the ballast bonds offer while adding excessive risk. Therefore, in many cases, it may be appropriate to think of these strategies as part of a return-seeking allocation and not a substitute for traditional bond holdings.

The guide below can help you evaluate and identify the level of risk being taken by your client's bond fund. You'll be able to better understand the risk/return tradeoffs of funds in these various Morningstar categories. In a market environment where core fundamentals matter, you don't want to have a manager straying from their mandate in search of yield.

How to evaluate risk exposures (versus benchmark and peers)

Risk factor Characteristics What are you looking for? Why does it matter?
Credit risk
Liquidity risk
Credit quality
  • Percentage of BBB-rated holdings
  • Percentage of high yield

These risk characteristics drive the potential for:

  • Price volatility
  • Downside risk
  • Complexity
Sector exposure
  • Out of benchmark/
    esoteric allocations
  • Concentration level
Issuer concentration
  • Top ten holdings percentage
  • Small-fund AUM
Interest rate risk Duration
  • Absolute level
  • Range over time
Leverage risk Derivatives
  • Negative cash balance
  • Zero or negative duration
  • Outsized returns

Notes:

  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • All investing is subject to risk, including possible loss of principal.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • Vanguard Advisor Portfolio Analytics and Consulting® has based this analysis on the allocation breakdown provided to Vanguard, holdings data obtained from applicable third-party sources, and Vanguard's portfolio construction methodology. Vanguard is not responsible for the accuracy of third-party data. Results are subject to change and will vary over different time periods. Vanguard is not responsible for an ongoing review of the allocation breakdown or for updating the information presented.
  • Vanguard is not responsible for determining the suitability of the results generated for any underlying client on whose behalf you use this information. As an investment advisor, it remains your responsibility to make a suitability determination for your clients, so you should review carefully the information presented and make your own determination as to its appropriateness.

 

Our insights straight
to your inbox

Our insights straight to your inbox

Receive our latest Advisor's Digest
research
and commentary sent the
first business
morning every week.

A weekly digest of our latest research and commentary. Topics include the economy and markets, portfolio strategy, ETFs, and practice management.


Fund openings/closings, fund manager changes, dividend distributions, webinars, and other events you might want to know about.



Already registered? Log on to
manage your
email subscriptions.

Advisor's Digest

for September 16, 2019

Advisor's Digest for September 16, 2019

Advisor's Digest

for September 16, 2019