Morningstar Advisor - June/July 2010 - 31

ered gospel that the Fed will alter its “exceptionally low for an extended period” language well in advance of any actual tightening. There’s some uncertainty about how the market might react to that signal alone, of course. As PIMCO’s cash guru, Paul McCulley, stated earlier this year, “The most important book at the Fed right now is a thesaurus.” Shorter borrowing rates often move in lock step with the Fed’s moves, but longer-term Treasury yields can have minds of their own. The market’s confidence in the Fed’s ability to keep inflation under wraps matters a lot. Many observers agree that still-large output gaps and high unemployment should keep inflation muted in the near term. The Fed also has many more tools at its disposal today to combat inflation—including hiking its target rate, draining bank reserves, and selling bonds—than it has to fight deflation, and investors know it. Simple supply-and-demand dynamics also play a role, and on that front, the case for lowerfor-longer Treasury yields weakens. Although the final amount depends on the speed and magnitude of an economic recovery, many analysts predict that the Treasury will have to issue more than $2 trillion in debt by the end of 2010 ($1.9 trillion was issued in 2009). The Treasury has also announced its intention to shift new issuance away from short-term T-bills into longer-term notes and bonds, which could apply upward pressure on longer maturity yields. Regardless of the economy’s near-term fortunes, the mounting entitlements of Medicare and Social Security, coupled with an aging U.S. population, argue loudest for more Treasury issuance and higher yields in coming years. However yields behave in coming months, they have less room to fall and more room to rise. What makes the threat of rising yields so combustible today is the lack of income available to offset price declines. If you take the yields on the various Barclays Capital indexes that track different bond sectors

and divide those by the indexes’ duration, you get a rough estimate of how high yields would have to rise before price declines would wipe out offsetting income. The answer for investment-grade bond sectors is around 50 to 100 basis points (see table). Investors who have moved into short-term bond funds believing that these funds’ low durations will protect them from rising rates could also be in for a shock. Short-term yields are so minuscule that there’s very little income to cushion the blow when the Fed eventually starts tightening, making losses a real possibility.
Staying in the Game

Low All Around: Yield/duration estimates how far yields would have to rise for price declines to wipe out returns from income.
Yield % Duration Yield/ Duration

Barclays US Aggregate

3.4

4.7

0.71

US Agg 1–3 Year US Agg 10+ Years US Treasury US Treasury 1–3 Years US Treasury 10–20 Years US Corporate CMBS ABS US MBS US Corp High Yield BB US Corp High Yield B
Barclays Emerging Markets Barclays G-6
Data as of April 30, 2010.

1.4 5.1 2.3 1.0 4.1 4.3 5.2 2.4 4.0 6.9 7.7
6.0

1.9 11.7 5.2 2.0 10.0 6.5 4.0 3.3 3.7
4.3

0.76 0.44 0.44 0.49 0.41 0.66 1.29 0.73 1.07
1.89

If bond investors understand just how rigged the game is, they may approach their bond allocations with a bit more trepidation. But judging by the billions that have continued to flow into bond funds so far in 2010, it seems that investors don’t appreciate that fixed income faces an uphill battle in coming years. Those who are chasing bond returns of the past decade should note that bonds no longer enjoy the income advantage or the tailwind of declining rates that propelled them over that period. Cash investors who’ve become impatient with near-zero money market yields may also be turning a blind eye to the risks they’re taking on for very little reward. Bonds still have a place in long-term asset allocations, however. Many factors come in to play when deciding whether to buy individual bonds or bond funds, but in a rising-rate environment, owning bond funds may have some advantages. When market rates rise, bond-fund yields adjust upward with a lag, as managers put the portfolio’s coupon payments to work at higher prevailing yields and trade out of less-price-sensitive shorter maturities into higher-yielding alternatives. Investors who buy individual bonds today are locking in yields near all-time lows. The peace of mind they get from not having to watch their funds’ net asset value decline is an illusion that masks the opportunity cost they’re paying for the privilege of tying money up in lower-yielding securities.

Barclays US Corp High Yield Idx 8.1

5.0 3.9
6.5

1.38 1.97
0.92

1.8

7.0

0.25

While no bond manager possesses a panacea for rising rates, the typical manager has many tools to protect his or her portfolios. Not all managers agree on the best way to prepare for a rising interest-rate environment today, though, so it’s critical to take a closer look at how they’re positioning their funds to fully understand the scenarios under which your investment will thrive or falter. Out of the diversified bond managers we survey, it appears that many are currently playing variations on one of two themes: The Gross or The Fuss.
The Gross

Some managers view the economy’s recovery as tentative, and they’re paring back exposure to the credit-sensitive bond sectors that have rallied over the past year. As a result, those with a narrowly focused mandate may hold sizable exposures to bonds backed by the U.S. government. While these sectors come with minimal credit risk, they can be highly sensitive to rising rates. Mortgages in

MorningstarAdvisor.com 31


http://www.MorningstarAdvisor.com

Morningstar Advisor - June/July 2010

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2010

Morningstar Advisor - June/July 2010
Contents
New on MorningstarAdvisor.com
Contributors
Letter From the Editor
What Risks to Bonds Are You Most Concerned About?
The Irrational Lizard Brain
Investment Briefs
The Problem With Financial Plans
Preparing for Turbulance
Different Models, Similar Results
The Game Is Up
Some People Are Bullish on Bonds
Bonds We Like
What Does Harry Markowitz Think?
Escape From the Pack
Four Picks for the Present
Rising Rates Could Affect Equities, Too
The Banking Sector Knocks on Wood
Back to Basics
On the Prowl for Smooth Operators
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
New at Morningstar
R-E-S-P-E-C-T
Morningstar Advisor - June/July 2010 - Morningstar Advisor - June/July 2010
Morningstar Advisor - June/July 2010 - Cover2
Morningstar Advisor - June/July 2010 - 1
Morningstar Advisor - June/July 2010 - 2
Morningstar Advisor - June/July 2010 - Contents
Morningstar Advisor - June/July 2010 - 4
Morningstar Advisor - June/July 2010 - 5
Morningstar Advisor - June/July 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - June/July 2010 - 7
Morningstar Advisor - June/July 2010 - Contributors
Morningstar Advisor - June/July 2010 - Letter From the Editor
Morningstar Advisor - June/July 2010 - What Risks to Bonds Are You Most Concerned About?
Morningstar Advisor - June/July 2010 - 11
Morningstar Advisor - June/July 2010 - 12
Morningstar Advisor - June/July 2010 - 13
Morningstar Advisor - June/July 2010 - The Irrational Lizard Brain
Morningstar Advisor - June/July 2010 - 15
Morningstar Advisor - June/July 2010 - Investment Briefs
Morningstar Advisor - June/July 2010 - 17
Morningstar Advisor - June/July 2010 - The Problem With Financial Plans
Morningstar Advisor - June/July 2010 - 19
Morningstar Advisor - June/July 2010 - 20
Morningstar Advisor - June/July 2010 - Preparing for Turbulance
Morningstar Advisor - June/July 2010 - 22
Morningstar Advisor - June/July 2010 - 23
Morningstar Advisor - June/July 2010 - Different Models, Similar Results
Morningstar Advisor - June/July 2010 - 25
Morningstar Advisor - June/July 2010 - 26
Morningstar Advisor - June/July 2010 - 27
Morningstar Advisor - June/July 2010 - 28
Morningstar Advisor - June/July 2010 - 29
Morningstar Advisor - June/July 2010 - The Game Is Up
Morningstar Advisor - June/July 2010 - 31
Morningstar Advisor - June/July 2010 - 32
Morningstar Advisor - June/July 2010 - 32a
Morningstar Advisor - June/July 2010 - 32b
Morningstar Advisor - June/July 2010 - 32c
Morningstar Advisor - June/July 2010 - 32d
Morningstar Advisor - June/July 2010 - 33
Morningstar Advisor - June/July 2010 - Some People Are Bullish on Bonds
Morningstar Advisor - June/July 2010 - 35
Morningstar Advisor - June/July 2010 - 36
Morningstar Advisor - June/July 2010 - Bonds We Like
Morningstar Advisor - June/July 2010 - 38
Morningstar Advisor - June/July 2010 - 39
Morningstar Advisor - June/July 2010 - 40
Morningstar Advisor - June/July 2010 - 41
Morningstar Advisor - June/July 2010 - 42
Morningstar Advisor - June/July 2010 - What Does Harry Markowitz Think?
Morningstar Advisor - June/July 2010 - 44
Morningstar Advisor - June/July 2010 - 45
Morningstar Advisor - June/July 2010 - 46
Morningstar Advisor - June/July 2010 - 47
Morningstar Advisor - June/July 2010 - 48
Morningstar Advisor - June/July 2010 - 49
Morningstar Advisor - June/July 2010 - 50
Morningstar Advisor - June/July 2010 - 51
Morningstar Advisor - June/July 2010 - Escape From the Pack
Morningstar Advisor - June/July 2010 - 53
Morningstar Advisor - June/July 2010 - 54
Morningstar Advisor - June/July 2010 - 55
Morningstar Advisor - June/July 2010 - 56
Morningstar Advisor - June/July 2010 - Four Picks for the Present
Morningstar Advisor - June/July 2010 - 58
Morningstar Advisor - June/July 2010 - 59
Morningstar Advisor - June/July 2010 - Rising Rates Could Affect Equities, Too
Morningstar Advisor - June/July 2010 - 61
Morningstar Advisor - June/July 2010 - 62
Morningstar Advisor - June/July 2010 - The Banking Sector Knocks on Wood
Morningstar Advisor - June/July 2010 - 64
Morningstar Advisor - June/July 2010 - 65
Morningstar Advisor - June/July 2010 - Back to Basics
Morningstar Advisor - June/July 2010 - 67
Morningstar Advisor - June/July 2010 - On the Prowl for Smooth Operators
Morningstar Advisor - June/July 2010 - 69
Morningstar Advisor - June/July 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - June/July 2010 - 71
Morningstar Advisor - June/July 2010 - 72
Morningstar Advisor - June/July 2010 - 73
Morningstar Advisor - June/July 2010 - 50 Most Popular ETFs
Morningstar Advisor - June/July 2010 - 75
Morningstar Advisor - June/July 2010 - Undervalued Stocks With Wide Moats
Morningstar Advisor - June/July 2010 - 77
Morningstar Advisor - June/July 2010 - 78
Morningstar Advisor - June/July 2010 - New at Morningstar
Morningstar Advisor - June/July 2010 - R-E-S-P-E-C-T
Morningstar Advisor - June/July 2010 - Cover3
Morningstar Advisor - June/July 2010 - Cover4
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2020q3
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2020q2
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2020q1
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2019winter
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2019fall
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2019summer
https://www.nxtbook.com/nxtbooks/morningstar/magazine_2019spring
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20191201
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20181011
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20180809
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20180607
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20180405
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20180203
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20181201
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20171011
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20170809
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20170607
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20170405
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20170203
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20171201
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20161011
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20160809
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20160607
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20160405
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20160203
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20161201
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20151011
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20150809
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20150607
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20150405
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20150203
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20151201
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20141011
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20140809
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20140607
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20140405
https://www.nxtbook.com/nxtbooks/morningstar/magazine_20140203
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20141201
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20131011
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20130809
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20130607
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20130405
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20130203
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20131201
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20121011
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20120809
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20120607
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20120405
https://www.nxtbook.com/nxtbooks/morningstar/investorconference2012
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20120203
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20121201
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20111011
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20110809
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20110607
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20110405
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20110203
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20111201
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20101011
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100809_lincoln
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100809
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100607_lincoln
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100607
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100405_lincoln
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100405
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20100203
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20101201
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20091011
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20090809
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20090607
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20090405
https://www.nxtbook.com/nxtbooks/morningstar/advisor_20090203
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2008fall
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2008summer
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2007spring
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2007fall
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2007summer
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2008spring
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2008catalog
https://www.nxtbook.com/nxtbooks/morningstar/advisor_2008winter
https://www.nxtbookmedia.com