Morningstar Advisor - August/September 2010 - 55

the event of a default—the issuer will place holders of bank loans high in the pecking order of creditors, making repayment more likely. However, when an issuer defaults, interest income, let alone rate adjustments, doesn’t arrive according to schedule, and this can handicap the loan’s ability to protect investors from rising rates (to say nothing of the distress that such uncertainty can cause).
Higher Yield, Less Damage

prices follow earnings, which can grow in line with inflation. The catch is higher volatility. It’s true that regular coupon payments tend to provide convertible bond investors greater downside protection than they’d find in the stock market (a real plus in inflationary periods, which often go hand in hand with greater fits and starts in stocks). However, the link between a convertible and its associated stock still tends to allow for greater volatility than investors may find elsewhere in the fixed-income market. To illustrate, over the 10 years that ended June 30, 2010, the Merrill Lynch Convertible Bond All Qualities Index had a 13.9% standard deviation of returns, more than three times that of the Barclays Capital U.S. Aggregate Bond Index over the same stretch. Second, not all convertible bonds are created equally. As with bank loans and high-yield bonds, investors need to evaluate the underlying credit quality of the issuer to limit the risk of default. They also need to assess the value of the convertible bond, which includes an analysis of its price and its associated stock and bond values. Whether a convertible bond acts more like a stock or a bond (thereby offering investors more or less inflation protection) depends heavily on these relationships.
International Refuge

Five Useful Vehicles to Guard Against Inflation
TIPS An obvious inflation hedge, but intermediate term is a cause for concern. Bank Loans Shortened duration without giving up much yield. High-Yield Bonds Nice yield cushion, but credit risk is trade-off. Convertible Bonds Higher inflation could mean higher stock prices. International Bonds Would Fed inflate a way out of fiscal mess?
About Morningstar Investment Services Morningstar Investment Services brings fee-based advisors the resources of an independent, experienced investment team. The team’s range of customizable stock, ETF, and mutual fund portfolios is guided by proprietary methodologies and leverages the well-recognized research of Morningstar, Inc. For more information, visit http://global. morningstar.com/mis or call 877-751-4208.

Along those lines, fixed-income investors should more generally consider the cushion that a higher yield can confer. Think about it—a 3% rise in prices is apt to do less damage to a bond with a 7% yield than it will to a bond with a 3% yield, because such inflation represents a far smaller share of the income stream in the former case than the latter. Yet, there’s a trade-off between swapping investment-grade bonds for high-yield bonds—credit risk. For example, high yield’s 2% median annual default rate is above other sectors of the fixed-income market, and it has climbed above 10% in periods of extreme stress. To strike the appropriate balance, we stick with high-yield bond fund managers who focus on the more highly rated rungs of the high-yield market. This somewhat depletes the resilience of such bonds in the face of rising prices, as their yields pale in comparison to those of the most-speculative credits. Yet, a 6.1% yield—which approximates the yield of Aquila Three Peaks High Income ATIPX, one of our favorite high-yield bond funds—is nothing to sneeze at.
Convertible Advantage

With an enormous federal deficit that threatens to grow larger comes the risk that the U.S. Federal Reserve will inflate away the government’s debts by printing money. That risk is far less acute in some foreign countries, which aren’t hobbled by stark fiscal imbalances and, in the case of several emerging economies, boast deep currency reserves. In short, these issuers are far less likely to use inflation as a cudgel, harming bondholders in the process. Given this, it stands to reason that investors fearing U.S. inflation would consider taking refuge in the foreign bonds.

Because investors can exchange convertible bonds for a fixed number of shares in a company’s stock, convertible bonds are more likely than other types of bonds to move in tandem with the underlying stock prices. This feature can be advantageous in inflationary periods because, in theory, stock

We think that this tactic has merit, but it’s not a panacea. For example, many developed economies, particularly in Europe, face fiscal woes similar to, if not worse than, those of the United States. And while emerging economies appear to be in superior fiscal shape, they could face inflationary pressures of their own, given their rapid growth and the speculative fervor that surrounds them. It’s also worth noting that a gradual devaluation of the greenback would hardly be welcome to holders of dollar-denominated sovereign debt. To mitigate these concerns, we favor experienced global-bond-fund managers with plenty of flexibility so we aren’t tied to a benchmark’s weighting in the United States or Europe. We similarly limit our exposure

MorningstarAdvisor.com 55


http://global.morningstar.com/mis http://global.morningstar.com/mis http://www.morningstaradvisor.com

Morningstar Advisor - August/September 2010

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2010

Morningstar Advisor - August/September 2010
Contents
New on MorningstarAdvisor.com
Contributors
Letter From the Editor
What Aspects of Health-Care Reform Will Most Affect Your Clients?
Bonds, Chicago Style
Investment Briefs
Which Risk Are You Managing?
Eye on the Prize
Advisors Can’t Rely on Fidelity Alone
Health Care Gets Back to Business
An Opportune Time to Bet the Pharm
Reform’s Impact on Other Health-Care Industries
Top Takeover Targets in Biotech
After Reform, Narrow-Moat Firms Have Strong Prospects in Diagnostics
Health-Care Investing Alive and Well
Quest for Knowledge
Four Picks for the Present
How to Make Your Bond Portfolio Inflation-Resistant
Weeding Through the Energy Patch
Uncertainty and Value in Basic Materials
Stock Market Doom-Busters
Hunting Down European Debt-Dodgers
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks With Wide Moats
VA Sales Slip a Bit in First Quarter
New at Morningstar
Star Wars, the Sequel
Morningstar Advisor - August/September 2010 - Morningstar Advisor - August/September 2010
Morningstar Advisor - August/September 2010 - Cover2
Morningstar Advisor - August/September 2010 - 1
Morningstar Advisor - August/September 2010 - 2
Morningstar Advisor - August/September 2010 - Contents
Morningstar Advisor - August/September 2010 - 4
Morningstar Advisor - August/September 2010 - 5
Morningstar Advisor - August/September 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - August/September 2010 - 7
Morningstar Advisor - August/September 2010 - Contributors
Morningstar Advisor - August/September 2010 - Letter From the Editor
Morningstar Advisor - August/September 2010 - What Aspects of Health-Care Reform Will Most Affect Your Clients?
Morningstar Advisor - August/September 2010 - 11
Morningstar Advisor - August/September 2010 - Bonds, Chicago Style
Morningstar Advisor - August/September 2010 - 13
Morningstar Advisor - August/September 2010 - Investment Briefs
Morningstar Advisor - August/September 2010 - 15
Morningstar Advisor - August/September 2010 - Which Risk Are You Managing?
Morningstar Advisor - August/September 2010 - 17
Morningstar Advisor - August/September 2010 - 18
Morningstar Advisor - August/September 2010 - Eye on the Prize
Morningstar Advisor - August/September 2010 - 20
Morningstar Advisor - August/September 2010 - 21
Morningstar Advisor - August/September 2010 - Advisors Can’t Rely on Fidelity Alone
Morningstar Advisor - August/September 2010 - 23
Morningstar Advisor - August/September 2010 - 24
Morningstar Advisor - August/September 2010 - 25
Morningstar Advisor - August/September 2010 - 26
Morningstar Advisor - August/September 2010 - Health Care Gets Back to Business
Morningstar Advisor - August/September 2010 - An Opportune Time to Bet the Pharm
Morningstar Advisor - August/September 2010 - 29
Morningstar Advisor - August/September 2010 - Reform’s Impact on Other Health-Care Industries
Morningstar Advisor - August/September 2010 - 31
Morningstar Advisor - August/September 2010 - 32
Morningstar Advisor - August/September 2010 - Top Takeover Targets in Biotech
Morningstar Advisor - August/September 2010 - 34
Morningstar Advisor - August/September 2010 - 35
Morningstar Advisor - August/September 2010 - After Reform, Narrow-Moat Firms Have Strong Prospects in Diagnostics
Morningstar Advisor - August/September 2010 - 37
Morningstar Advisor - August/September 2010 - 38
Morningstar Advisor - August/September 2010 - 39
Morningstar Advisor - August/September 2010 - 40
Morningstar Advisor - August/September 2010 - Health-Care Investing Alive and Well
Morningstar Advisor - August/September 2010 - 42
Morningstar Advisor - August/September 2010 - 43
Morningstar Advisor - August/September 2010 - 44
Morningstar Advisor - August/September 2010 - 45
Morningstar Advisor - August/September 2010 - 46
Morningstar Advisor - August/September 2010 - 47
Morningstar Advisor - August/September 2010 - 48
Morningstar Advisor - August/September 2010 - Quest for Knowledge
Morningstar Advisor - August/September 2010 - 50
Morningstar Advisor - August/September 2010 - 51
Morningstar Advisor - August/September 2010 - Four Picks for the Present
Morningstar Advisor - August/September 2010 - 53
Morningstar Advisor - August/September 2010 - How to Make Your Bond Portfolio Inflation-Resistant
Morningstar Advisor - August/September 2010 - 55
Morningstar Advisor - August/September 2010 - 56
Morningstar Advisor - August/September 2010 - 57
Morningstar Advisor - August/September 2010 - Weeding Through the Energy Patch
Morningstar Advisor - August/September 2010 - 59
Morningstar Advisor - August/September 2010 - 60
Morningstar Advisor - August/September 2010 - Uncertainty and Value in Basic Materials
Morningstar Advisor - August/September 2010 - 62
Morningstar Advisor - August/September 2010 - 63
Morningstar Advisor - August/September 2010 - Stock Market Doom-Busters
Morningstar Advisor - August/September 2010 - 65
Morningstar Advisor - August/September 2010 - Hunting Down European Debt-Dodgers
Morningstar Advisor - August/September 2010 - 67
Morningstar Advisor - August/September 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - August/September 2010 - 69
Morningstar Advisor - August/September 2010 - 70
Morningstar Advisor - August/September 2010 - 71
Morningstar Advisor - August/September 2010 - 50 Most Popular Equity ETFs
Morningstar Advisor - August/September 2010 - 73
Morningstar Advisor - August/September 2010 - Undervalued Stocks With Wide Moats
Morningstar Advisor - August/September 2010 - 75
Morningstar Advisor - August/September 2010 - VA Sales Slip a Bit in First Quarter
Morningstar Advisor - August/September 2010 - 77
Morningstar Advisor - August/September 2010 - 78
Morningstar Advisor - August/September 2010 - New at Morningstar
Morningstar Advisor - August/September 2010 - Star Wars, the Sequel
Morningstar Advisor - August/September 2010 - Cover3
Morningstar Advisor - August/September 2010 - Cover4
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