Morningstar Advisor - April/May 2013 - (Page 14)
Know-How
How to Assess a Portfolio’s Bond Risk
By Christine Benz and Eric Jacobson
Duration and credit quality only tell part of the story.
Bond yields have never been lower, but
investors continue to flock to bond
funds. The taxable-bond group gained
more than $260 million in new assets
in 2012, according to Morningstar
asset flows data, and that was on top of
$50 billion in new inflows in 2011.
Municipal-bond funds gathered an
additional $50 billion in new assets last
year. But are bond investors courting
more risk than they realize? Yields
will eventually go up, and when they do,
bond prices might suffer. Investors
should understand the risks that
lurk in their fixed-income portfolios.
Here’s how.
1 Check Your Duration…
Duration is an estimate of how much interestrate sensitivity bond funds have to changes of
market yields. For example, if a fund’s duration
is 2.5 years, simply multiple that number
by 100 basis points, or 1%. A fund with a
duration of 2.5 years should expect to lose
2.5% if interest rates move up one full
percentage point. The higher the duration, the
more sensitive the portfolio is to moves of
interest rates. This comes with a few caveats.
It’s not a foolproof number. It is a mathematical
construct and cannot possibly account for
changes in interest rates in every rate scenario.
But overall, it is a pretty good estimate
of what investors can expect from a short shock
to interest rates in one direction or the other.
Duration also works better in some bond
14 Morningstar Advisor April/May 2013
categories than others. Duration in traditional
fixed-income categories, such as government
bonds, works best. It’s less reliable in
categories such as multisector and high-yield
bond. Therefore, a high-yield fund with
a duration that floats between three and
six years isn’t going to be as rate-sensitive as a
three- to six-year high-quality, core bond fund.
2 …Then, Your Credit Quality
A fund’s average credit quality is a weighted
average based on the default probability
of corporate bonds. But don’t put too much
emphasis on this figure. Because the
default probabilities of junk bonds have been
so high over the recent decades, numbers are
skewed. The average credit-quality of any
portfolio holding junk bonds is going to be low.
Just as important is the breakdown of
the fund’s credit strata, AAA on down to high
yield. Credit quality is a good place to look to
determine how risky a bond fund is.
3 Keep an Eye
on Sector Weightings
Where a fund is putting money might say
more about risk than its credit quality.
For example, a lot of emerging-markets debt is
relatively high-rated because many of these
countries have improved their fiscal health.
But emerging-markets debt tends to volatile in
the marketplace. So, even though things
might look okay on the credit side, a large
weighting of emerging-markets bonds could
mean trouble in a big sell-off.
4 Don’t Get Too High on Yield
Investors will usually be able to see the roots
of risks by paying attention to duration,
credit quality, and sector weightings. But if
you’re still uncertain, look at yield. If
it’s significantly higher than the peer group’s,
bank on the fact that there is extra risk built
into the portfolio somewhere.
5 Shelters From the Storm
Investors who want to shield their portfolios
from excessive interest-rate sensitivity
should head to the short-term bond category.
Below are three options that have a Morningstar Analyst Rating of Gold:
Vanguard Short-Term Bond Index VBISX is a
plain-vanilla index offering that invests mostly
in government and high-grade corporate bonds.
There’s a bit of credit risk here, but being a
Vanguard fund, it’s predictable and very cheap.
T. Rowe Price Short-Term Bond PRWBX is a
moderate fund that avoids interest-rate and
credit-sensitive bonds. Instead, the bulk
of the fund is in investment-grade corporates;
about 20% is in government mortgages.
PIMCO Low Duration PTLAX is riskier. It has
some high-yield and foreign and emergingmarkets bonds. But Bill Gross and team are
top-notch and have an excellent record here. K
Christine Benz is Morningstar’s director of personal
finance. Eric Jacobson is a senior fund analyst
on the active funds research team at Morningstar.
Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013
Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot
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