Morningstar - Fall 2019 - 34

Spotlight: Bonds

Rocky Times Ahead for Bond Investors?
Falling yields, credit quality, and asset mix
are just a few things to think about.
Annual Fund Flows by Morningstar Rating 1998-2018
BONDS

QQQ
QQQQ
QQQQQ
Tom Lauricella and Christine Benz

QQ

Q

Bond markets have enjoyed one of the greatest
30- to 40-year bull markets on record.
With bond yields falling from highs of more than
15% in the early 1980s to lows of around
1% today, the asset class has delivered outsize
returns by historical standards for investors
on a risk-adjusted basis and on an overall basis.
That's been good news for bond investors.
But that rally has left yields at historically low
levels ( E X H IB IT 1 ).

valued. Morningstar Investment Management
says that, at a high level, valuation-driven
investing is built on two clear principles. First,
investors need to believe an asset has a "fair value"
that can be estimated through careful analysis.
Second, they need to believe that, while the
price of an asset may deviate significantly from fair
value in the short term, it tends to return to fair
value over the long term.
Morningstar Investment Management refers to
this deviation from "fair value" as "valuationNet Flows
implied returns," which can be Estimated
assessed using
four
$1,000B
key conviction pillars.

Why does this matter? Because bond markets
have a curious feature: Yields on government
bonds at a point in time tend to be a good
predictor of what returns will be for the next 10
years. E X HIB IT 2 from Morningstar Investment
Management shows the tight connection.

Absolute Valuation
Understand clearly what each asset can be
500
expected to deliver over a 10-year time horizon.

For government bonds, the starting yield has
been an incredibly powerful determinant of
future returns. This is in part because default risk
is considered to be very low, and thus, the
contributors to risk and return become simplified.

Relative Valuation
Understand how well the asset ranks compared 0
with other markets.

2012

Contrarian Sentiment
-500
Identify whether current sentiment is supportive
to our conviction in a long-term context.
-1,000
2014
2016
2018
Fundamental Risk

Interest Rates and Inflation An historic run by bonds has led to extremely low yields.

Understand clearly the range of possible scenarios,
as well as any risk that would cause our base
case to be inaccurate over the investment horizon.

1998

2000

2002

2004

There are other ways to assess value in the bond
market, similar to the ways that stocks are
2006

2008

2010

EXHIBIT 1

10-Yr Treasury Yield

Fed Funds

CPI
20%

15

10

2.5
2.4
2.0

5

0
-5

1960

1970

1980

1990

2000

2010

2019

Source: Federal Reserve. Data as of 03/31/2019.

34

June 2016

December 2018

Morningstar Fall 2019

June 2018

May 2019

June 2019

Yield
3.0%

What Comes Next?
A properly constructed, long-term investment
strategy, by definition, shouldn't require
portfolio changes in response to market swings.
But some investors with shorter time
horizons may decide to make tilts within their
broader allocations.

Investors should remember that timing ups
and downs of the bond market is hard, as it is
with any investment. Sarah Bush, director
of Morningstar Research Services' fixed-income
manager research, says that big bets on
changes in the economy, especially significant
adjustments to portfolio interest-rate
sensitivity, can be difficult for even professional
investors to get right consistently. For much
of the postcrisis period, many intermediate-term
fund managers ran their portfolios with a tilt
Morningstar - Fall 2019

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