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
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

Morningstar Advisor - April/May 2013