Morningstar Advisor - August/September 2010 - 56

In Practice

An Inflation-Fighter Bond Portfolio
Sector Index Weight

makes downside protection a high priority in the bank-loan space. Active management can also bear fruit in “safer” sectors of the fixed-income market, such as TIPS. We find that experienced fund managers in that sector can boost returns by adjusting a fund’s interest-rate exposure or identifying relative valuation opportunities. A look at historical data over the longest common stretch and during a period of rising inflation suggests this hypothetical portfolio has earned competitive real returns relative to the real returns of the Barclays Capital U.S. Aggregate Bond Index and the U.S. Intermediate-Term Government Index, which we used to gauge the portfolio’s ability to withstand changes in real interest rates. We’d take this historical data with a grain of salt, however. Changing market dynamics mean past performance is never a foolproof indication of what’s to come. Furthermore, the TIPS market only stretches back to the 1990s, which limits our ability to test the portfolio in periods of higher inflation, such as the late 1970s and early 1980s. The takeaway is not that this portfolio is the optimal construction for all fixed-income investors looking for a reprieve from inflation. Rather, our goal is to drive home the notion that investors tied to the bond market are not sitting ducks when prices start to rise. With a working knowledge of the bond market and a solid understanding of personal risk tolerances, investors can temper inflationary pressures within the fixed-income world. K
Marta Norton, CFA, is an investment manager with Morningstar Investment Services, Inc.

Core Bond TIPS Bank Loans High-Yield Bonds Convertibles Emerging-Markets Currency

Barclays Capital Global Aggregate Bond Index Merrill Lynch Global Government Inflation Linked Index Credit Suisse Leveraged Loan Index Barclays Capital U.S. Corporate High Yield Index Merrill Lynch Convertible Bond All Qualities Index JP Morgan Emerging Local Markets Index Plus

40% 20% 15% 10% 10% 5%

For illustrative purposes only; the portfolio is hypothetical and does not reflect any actual client portfolio.

How It Holds Up
Common Period: 01/1998–06/2010 Portfolio/Index 2 Annlzd Real Rtn Std Dev Avg Drawdown Inflation Period: 06/2002–09/2005 Annlzd Real Rtn Std Dev Avg Drawdown

Inflation-Fighter Bond Portfolio Barclays Capital U.S. Aggregate Bond Index Ibbotson SBBI U.S. Inter Govt Index—Infl Adj

3.58% 3.56% 3.49%

4.98% 3.66% 5.17%

–2.63% –1.86% –3.59%

5.41% 2.10% 1.51%

4.03% 4.15% 5.64%

–1.49% –1.85% –4.09%

For illustrative purposes only; past performance is not a guarantee of future results. The hypothetical bond portfolio does not reflect actual client portfolios and is gross of any program fees; if fees were included, returns would be less.

to emerging markets and rely solely on experienced and well-resourced emergingmarkets bond teams that exercise prudence. We’re particularly interested in managers who offer exposure to bonds denominated in local currency, so we can diversify away from the U.S. dollar.
Inflation Fighters

carving out each allocation. For example, while bank loans and high-yield bonds have distinct attributes, they’re both forms of sub-investment-grade credit and, thus, face similar risks, like an economic retrenchment. However, we’ve allocated a touch more to bank loans, given their utility as the Fed begins to tighten money supply. We’re trying to be judicious about introducing volatility to the portfolio, particularly via equity-sensitive instruments like convertibles and even high-yield bonds. And, of course, we sought to maintain and even enhance the portfolio’s yield, a goal we couldn’t have realized by piling into bank loans and TIPS alone, because yields on such bonds tend to be lower in absolute terms. In practice, investors can further reduce credit risk and volatility by relying on conservative fund managers. For example, Aquila Three Peaks High Income and Harbor High-Yield Bond HYFAX have exacting standards for highyield issuers, while Fidelity Floating-Rate FFRHX

To illustrate what an inflation-resistant bond portfolio could look like, we created a mock-up of a core-satellite portfolio consisting of the Barclays Global Aggregate Bond Index and the sectors previously mentioned. By using a global-bond index in place of the Barclays Capital U.S. Aggregate Bond Index, we loosened the portfolio’s ties to the U.S. economy. We then added a 20% stake in inflation-linked bonds such as U.S. TIPS, which we would bump higher if not for our concern over rising real rates. To a large extent, we’re trading inflation risk for credit risk in the rest of the portfolio, and we’ve tried to be cognizant of this when

56 Morningstar Advisor August/September 2010

Morningstar Advisor - August/September 2010

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