Rising Risk

IT’S BUYER BEWARE for bond fund investors. Three big risks have snuck up on today’s fund shareholders, which—taken together—mean higher volatility and lower returns.

I discussed these pitfalls with Ben Johnson, director of global exchange-traded fund research at Morningstar, the Chicago investment research firm. “In recent years, the market’s standards have loosened significantly and durations have lengthened,” Johnson told me. “People are generally willing to lend money to less creditworthy borrowers for longer terms…. That likely spells more risk and less return for the foreseeable future.”

 Let’s count the ways that today’s market is less favorable for bond fund investors:

• Higher interest rate risk. Total bond market index funds—the bread-and-butter investment grade option for many investors, as well as a key building block for some balanced, asset allocation and target-date funds—are a lot more vulnerable to rising rates than they used to be. Johnson noted that the duration of Vanguard Total Bond Market Index ETF has jumped to 6.6 years from almost 4.8 years in 2007. Duration is a measure of interest rate risk. That means investors stand to lose nearly 7% for every one percentage point increase in interest rates, versus less than 5% just 14 years ago. That’s 40% greater risk. That said, if interest rates fell, the rewards today would also be greater.
• More credit risk. Total bond market funds—which typically track the Bloomberg Barclays U.S. Aggregate Bond Index—carry more credit risk in their corporate bond holdings than they used to. In other words, there’s a greater chance that some of the bonds within the index will default.
• Slimmer rewards. The extra yield that these riskier-than-usual investment grade corporate bonds are paying over Treasury bonds is near record lows. “You’re getting paid incrementally less to take on incrementally more risk, which isn’t all that enticing a proposition,” Johnson said. “You have to realize that, especially if you’re opting for indexed exposure to the bond market, you’re telling the market that you’re going to take whatever it is that it’ll give to you.”

Despite all that, bonds still play a critical role in diversifying a portfolio that’s made up mostly of stocks or stock funds. They provide “ballast” when stocks are sinking, Johnson said. It’s just that investors in plain-vanilla total bond index funds are going to have a rockier road than they may expect, because their bond funds are primed for more volatility.

Johnson’s words called to mind what my grandfather used to tell my father when my dad was a child and sitting at the dinner table: “You’ll eat it and like it.” Still, unlike Depression-era children, bond fund investors have options. Compared with their counterparts in stock funds, active bond fund managers—those who pick and choose which bonds they think will outperform—have shown greater ability to beat the indexes. That’s because the bond market has certain “structural inefficiencies,” Johnson said.

For instance, many institutions are required to invest only in investment grade bonds. In periods of upheaval, when some borrowers have their ratings cut, that can lead to forced selling. Active managers can scoop up these “fallen angels” and then profit if these bonds return to investment grade status.

Despite paltry yields, Johnson said investors with shorter time horizons—and thus a greater need for bonds that hold their value in a market downdraft—are likely better off in short- or intermediate-term Treasury bond funds. Meanwhile, those with more time before retirement might consider funds with corporate bond exposure.

What not to do: Take your high-quality bond holdings and replace them with high-yield junk bonds or dividend-paying stocks. The extra yield on junk isn’t enough to compensate for their credit risk, while stocks are not bonds, even if they do offer mouth-watering yields.

“I would never suggest investors consider dividend-paying equities, no matter how high quality the names, as a substitute for fixed-income exposure,” Johnson said. “Stocks are stocks, bonds are bonds, and never the two shall cross when it comes to making asset allocation decisions. It’s antithetical to diversification.”

William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.

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