16
The Federal Reserve surprised almost everyone when
it pushed back its tapering of bond purchases. The
news was warmly received in the stock market, but
bond investors are still feeling indigestion.
The average intermediate-bond fund is down about
2%
for the year to date through October, and long-
term bonds and Treasury Inflation-Protected Securi-
ties funds are down
4%
and
6%
, respectively. As
a result, we saw a huge outflow from taxable-bond
funds over the summer. All told, investors with-
drew about $
60
billion from June through August.
The May-July interest-rate tremor sent investors
scrambling out of rate-sensitive bonds. Government-
bond funds—including those focusing on
TIPS
and
GNMA
s—got the heave-ho. So did a lot of core inter-
mediate-term bond funds like
PIMCO Total
Return
PTTRX
.
But offsetting outflows in these groups were strong
inflows into other fixed-income categories, including
non-traditional-bond funds like
PIMCO Uncon-
strained Bond
PUBDX
, and the hot category of the
moment, bank-loan, or floating-rate, funds. Investors
appear to be trading interest-rate risk for another
type of risk—credit risk.
The risk, however, is that by jettisoning high-quality
bonds in favor of more credit-sensitive ones, they’re
throwing out their portfolios’ ballast—investments
that may hold up well when stocks do not. And in the
process, their portfolios are tacitly banking on one
type of outcome—a sustained economic recovery—
while ruling out the possibility that there will be
setbacks along the way.
Not Entirely Irrational
In many respects, investors’ recent preferences make
a lot of sense. Interest rates don’t have a lot of room
to move down, and Federal Reserve officials have
been telegraphing signals that they might soon begin
tapering the Fed’s extended bond-buying program—
which has buoyed bond prices while pushing down
on yields. Bond market participants have attempted to
get ahead of Fed actions, selling Treasuries and other
rate-sensitive bonds and pushing up their yields. The
yield on the
10
-year Treasury hit
2
.
823%
on Aug.
15
,
its highest level in two years. With the strong possibil-
ity of more bond market trouble to come, it’s hard
to blame investors for selling some of the categories
they’ve been dumping.
Meanwhile, rising rates are often the outgrowth of
an improving economy, so investors’ embrace of
credit-sensitive bond funds isn’t unreasonable, either.
Floating-rate, or bank-loan, funds, a formerly niche
investment type that has seen a whopping $
54
billion
in new asset inflows over the past year through
August, appear especially well-poised to benefit from
an economic environment that features rising bond
yields and improving growth. The fact that the interest
rates on floating-rate loans reset along with prevail-
ing market yields gives them shelter from rising rates,
something other bond categories do not offer. If eco-
nomic growth picks up, loan-default rates will drop.
Rethink Your Ballast
Yet even as investors’ recent bond preferences make
sense, they could take them too far, thereby limit-
ing the diversification in their portfolios. And, in turn,
they could negate the key reason most of us hold
bonds—to have fairly liquid assets we could tap in a
pinch when the rest of our portfolios are down in
the dumps.
That’s because the credit-sensitive bonds that inves-
tors have recently been buying have historically had a
much higher correlation with stocks than the high-
quality bonds they’ve been selling. That relationship
was on stark display during the recent bear market,
when some high-yield and bank-loan funds posted
losses in line with equity funds.
That might not be prudent, in the view of Bob Johnson,
Morningstar’s director of economic analysis. “Inter-
mediate term, I think the economy is fine, but not the
Rethink Your Bond-Fund Ballast
Portfolio Matters
|
Christine Benz
Welcome to our
new feature,
Portfolio Matters,
by Christine Benz,
Morningstar’s director of
personal finance. We’re
thrilled to have Christine
help you manage the port-
folio challenges that you
face each month.Christine
will address personal
finance issues with prac-
tical solutions through-
out the year.
