Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

A bond is a pretty simple investment. Governments and corporations issue bonds to raise money, and in return, they offer bond investors regular interest payments and a return of the principal investment at the bonds’ maturity dates. Investors—especially income-seeking investors, such as retirees—like bonds for their steady stream of income and stability when compared with stocks.

Not surprisingly, bond funds are portfolio staples for many investors—especially retirees. According to Morningstar’s latest Fund Flows Report, nearly $3 trillion rests in taxable bond funds today. In total, taxable bond fund assets represent more than one fifth of all fund assets.

But choosing a suitable taxable bond fund is more difficult than it might seem. The considerations are multiple and can be intricate. There are credit-quality decisions, interest-rate-sensitivity choices, and of course, determining whether you should invest in a single core holding or add supporting players around a core.

Given the sizable role taxable bond funds play in investor portfolios, here is a checklist for investors to follow as they evaluate their current fixed-income allocations or consider adding taxable bond exposure to their portfolios.

Core Only, or Core and Support?
“Be sure to start building your bond fund portfolio with core, intermediate-term funds that give you a lot of diversification in a single holding,” recommends Morningstar director of personal finance Christine Benz. Investors seeking diversification benefits for an equity-heavy portfolio can be well served by higher-quality, intermediate-term core bond funds blending government bonds, mortgage-backed securities, and high-quality corporate debt.

Some investors may want to go beyond core bond funds, though. For instance, investors with a modest equity stake and heavy fixed-income allocation might choose to own a few bond funds, in an attempt to diversify. They can start by supplementing a core bond choice with high-yield and bank-loan funds. As Benz has noted, both types of funds have behaved more in step with the stock market than the bond market of late and, therefore, are good diversifiers to a core holding. In addition, foreign-bond funds can provide global diversification across interest-rate and inflationary environments.

Investors looking for a little bit of all of these bond types in one package might consider flexible bond funds. These funds invest in government and corporate paper, U.S. and foreign bonds, and high- and low-quality credits. “Investors will find strategies offering a range of interest-rate, credit, and currency risk,” notes director of fixed-income strategies Michael Herbst. Specifically, funds in the non-traditional-bond category carry “a higher degree of interest-rate flexibility or the ability to use shorting,” adds Herbst.

Finally, there is one bond fund type that Benz suggests retirees specifically add to their bond portfolios, whether they are taking a core-only or core-and-support approach: inflation-protected bond funds. “Such individuals rely on at least part of their portfolios for living expenses and, therefore, they are not receiving an inflation adjustment in that part of their ‘paychecks,’” she says. Inflation-protected bond funds can fill that role.

Credit Quality
Yield is tough to come by. As of this writing, the yield on the 30-year Treasury dwells below 3% and 10-year paper hovers at just 2%. As a result, it is tempting to buy riskier bonds—those bonds issued by corporations rather than the government, or even those bonds rated below high quality. As compensation for taking on that extra so-called credit risk, these bonds offer higher yields.

What is the harm? For one, lower-quality bonds (such as those purchased by high-yield and bank-loan funds) can get hammered during flight-to-quality periods. “For example, during 2008’s credit crisis, high-yield and bank-loan funds declined an average 29.8% and 26.4%, respectively,” notes analyst Sarah Bush. During that same time frame, high-quality government-bond funds notched gains.

As has already been noted, lower-quality credits tend to behave more like equities than bonds. So, if you are dipping into lower-rated credits to pick up extra yield in your core, you are making your portfolio more sensitive to the equity market.

For the core of your fixed-income portfolio, focus on funds whose average credit quality land in the mid- to high-quality range. Relegate lower-credit-quality plays to supporting roles in your portfolio.

Interest-Rate Sensitivity
Investors generally think of high-quality bond funds as “safe” investments. While such funds pose modest credit risk (in other words, their issuers are unlikely to default on their interest payments), they can carry significant interest-rate risk. Because most bonds pay out a fixed rate of interest until their maturity, they are susceptible to changes in interest rates (also known as interest-rate risk). When rates rise, the prices of already-issued bonds can fall because an investor can go out into the market and buy a similar-quality bond yielding more.

As a result, investors holding interest-rate-sensitive bond funds can experience huge swings in performance. “The typical long-term government-bond fund lost more than 13% when yields rose in 2013, and gained 22% in 2014’s Treasury rally,” says Bush. Meanwhile, intermediate-term government funds lost less than 3%, on average, in 2013 while gaining almost 5% in 2014.

For the core of your fixed-income portfolio, go for funds with moderate interest-rate sensitivity; you will end up with less volatility, year over year. Long-duration funds with extensive interest-rate sensitivity are best suited to those who want to tilt their portfolios to play a falling-interest-rate scenario—and given the specter of higher rates, these funds may be even less appropriate choices today than they have been in the past.

Expenses
Expenses are an underrated element of a fund’s performance; which you ignore at your own peril. Research into the predictive power of fees has found that funds carrying lower expenses enjoyed greater “success rates” (defined as survival and outperformance over a subsequent period) than funds levying higher expenses.

Price is an even more important consideration with core bond funds than some other fund types. That is because the range of returns among funds in these comparatively staid categories is relatively narrow. Core bond funds with higher expense ratios to clear find themselves at a return disadvantage. To stay competitive, some higher-cost funds may take on additional risks, such as delving into lower-quality credits or extending their durations. When it comes to bond funds, warns Benz, “high expenses correlate neatly with risk-taking.”

As a rule of thumb, focus on bond funds with low or below-average fee levels. You can find a fund’s fee level on the Quote page of any fund report; view a full expense breakdown by clicking the “Expense” link on the Quote page.

 

©Morningstar 2015. All Rights Reserved. Used with permission.