17
Morningstar FundInvestor
February 2
014
and when yields pop up. Funds, meanwhile, have
bonds maturing all the time and therefore have the
option to trade into higher-yielding securities as
they become available, even though they may take
a hit to their principal values as yields rise. And
although buying individual government bonds or corp-
orate bonds issued by
AAA
rated companies is a
reasonably safe strategy, smaller investors venturing
beyond gilt-edged bonds may have trouble conduct-
ing adequate research on such credits and assembling
a portfolio with adequate diversification. Trading
costs also can be an issue for small investors.
Tilting Toward Credit Sensitivity
The Strategy:
Another tack bond investors have been
taking lately has been to venture into more credit-
sensitive bond types in lieu of higher-quality fixed-
income funds. Bank-loan, unconstrained bond, and,
to a lesser extent, high-yield bond funds have been
seeing massive new inflows, even as investors have
hit the exits at traditional core bond funds such as
PIMCO Total Return
PTTRX
. Credit-sensitive bonds
have higher yields attached to them than higher-
quality bonds, and that yield provides a better cushion
in a period of rising rates than high-quality bonds.
Bank-loan funds have an additional level of impervi-
ousness in a period of rising rates, in that their yields
adjust upward to keep pace with prevailing rates.
Buyers of lower-quality credits also can take comfort
in the fact that the economy seems to be recovering,
so broad-scale defaults are unlikely.
The Risks:
Even though it’s not unreasonable to
assume that the economy will continue to mend, and
that will serve as a positive for lower-quality credits,
there’s always the risk that the economy could experi-
ence a hiccup or worse, which would tend to depress
the prices of lower-quality bonds. And while such
bonds typically offer higher yields than higher-quality
credits, that yield differential has narrowed consider-
ably over the past few years. For example, the yield
spread between the Bank of America Merrill Lynch
High Yield Index and Treasuries was recently
3
.
92%
—
not as low as it got in late
2007
(about
2
.
5%
) but cer-
tainly low relative to historic norms. Perhaps an even
bigger issue is that lower-quality bonds may not
fulfill one of the key roles investors look for bonds
to fill: diversification.
Buying Dividend-Paying Stocks
The Strategy:
With bond yields as depressed as
they’ve been, dividend-paying stocks have emerged
as a compelling alternative for many investors,
offering yields that are competitive with or in some
cases higher than high-quality bond yields. Right
now, for example, the yield on the Barclays Aggregate
Bond Index is just about
25
basis points higher than
that of the S
&
P
500
, and it’s not hard to find high-
quality companies with yields that are much higher
than the S
&
P’s. Investors in dividend-paying stocks
can also benefit through share-price appreciation and
if companies increase their dividends.
The Risks:
The biggest drawback to using income-
producing equities to supplant fixed-income securities
is volatility. The median equity fund with a dividend
focus has a five-year standard deviation of about
15
,
whereas the typical intermediate-term bond fund
has a standard deviation of just
3
. Long-term dividend-
focused investors might say they’re unperturbed by
short-term volatility, but if they’re relying on their port-
folios for dividend income and their payouts and/or
emergency funds don’t cover an unplanned expense,
they could be forced to raid their principal when it’s at
a low ebb. Moreover, while income-producing stocks
aren’t as directly affected by interest-rate changes
as are bonds, they’re not impervious, either. The past
summer’s interest-rate shocks caused shudders
across a host of income-producing equity sectors,
especially utilities.
œ
Contact Christine Benz at
