Morningstar - Q2 2021 - 32

Spotlight: Role of Bonds

market shocks. It also underscores the importance
of not using a muni-bond fund as a source of
liquid reserves, in that the muni market's bouts
of illiquidity are an inopportune time to sell.
High-yield munis' higher correlation with equities,
meanwhile, indicates that such bonds would
best be used alongside higher-quality muni bonds
(or high-quality taxable bonds), assuming
the investor was aiming to diversify equity risk.
Time Horizon Is Also Key
In addition to highlighting the value of
diversification, last year's market action also
underscores the importance of time horizon
and anticipated holding period when deciding
which bond funds to invest in-or whether
to hold them at all if an investor's time horizon is
too short and certainty is needed.

For near-term cash outlays, there's only one asset
class that reliably stays positive: cash. It's a drag
on returns in upward-trending markets, and
it's not often that bonds lose money at the same
time stocks do, but cash is there in case they do.
Meanwhile, past performance suggests that
investors in bond funds should be prepared
for periodic bobbles in their principal values. But
that's OK, provided the investor's holding
period is reasonable given the frequency, depth,
and duration of those dips. For the safest bond
funds, such as short- and intermediate-term
government bonds, losses have usually been brief
and have quickly recovered. For riskier bond
types, losses have been deeper, and it has taken
longer to recover from them.
To help assess whether a given bond-fund type
is a good fit given a holding period, rollingperiod returns and maximum drawdowns provide a
useful lens. The shorter the period until investors
need to begin drawing on their money, the
less they'll want to hold those funds in bond funds
that have a history of frequent losses over a
similarly short period, especially if those losses
have been sharp and sustained. For example,
the typical fund in the short-term bond category,
which is made up of funds that mostly hold
investment-grade corporates, has posted losses in
about 6% of rolling 12-month periods since the
early 1970s. The worst drawdown for short-term

Morningstar Q2 2021

bond funds over the past 20 years came during the
global financial crisis, when the typical fund
in the category lost a cumulative 7%, and investors
weren't back to break-even for another 15 months.
Short-term government-bond funds were
generally safer. Interestingly, their losses over
12-month periods were somewhat more
frequent than short-term bond funds; they landed
in the red in about 7.5% of rolling one-year
periods. But their worst drawdown, 1.6%
in April/May 2004, was much lower, too, and they
recovered fully six months later.
Taken together, those data suggest that shortterm bond funds (whether broadly diversified funds
or government-focused options) aren't a cash
substitute and that investors should be prepared
for drops in value that last for six months to
more than a year. But such losses haven't been
terribly frequent or deep, and the funds have
readily recovered from them. Short-term
bond funds can be used as next-line reserves in
case the cash cushion becomes depleted
and an investor has additional cash flow needs.
Meanwhile, intermediate-term core bond funds
have experienced deeper troughs and a
higher percentage of one-year rolling periods
when their returns were in the red. Therefore,
investors should hold them with an even longer
time horizon in mind than short-term vehicles.
Intermediate-term core bond funds have posted
losses in 19% of rolling one-year periods
since the 1950s; for core-plus bond funds, it was
20%. And the worst drawdowns for both
categories were more painful than the short-term
categories. In their worst drawdowns in
Morningstar's database, intermediate core and
core-plus bond funds experienced losses of
9% and 10%, respectively, during the financial
crisis. Investors weren't back to break-even
until the summer of 2009, 17 months after they
started to fall. Meanwhile, the maximum
drawdown for intermediate-term government-bond
funds was much shallower, about 3.6% between
May 2013 and August 2014.
Further out on the risk spectrum, data about
high-yield bond performance illustrate
why it makes sense to think of them as an

alternative to stocks, not bonds, and maintain
an accordingly long time horizon. The typical
high-yield bond fund lost about a third of
its value during the financial crisis. The drawdown
was also prolonged. High-yield bonds began
to slide in June 2007, and investors weren't back
to break-even until December 2009-
roughly 2.5 years. In rolling three-year periods,
high-yield bond funds posted losses about
12% of the time; funds in the group had losses
in 7% of rolling five-year periods.
Of course, past performance isn't necessarily
prologue; for one thing, today's very low
starting yields mean that bond funds have much
less of a cushion against price drops than
was the case during the financial crisis. But
observing the frequency and magnitude
of losses of various bond funds over history, and
during the recent market shock, too, can help
investors determine where to slot them in
their portfolios-or whether they're a fit at all.
The Continuing Benefits of Diversification
As we've seen, bonds still have a crucial
role to play in portfolios-that of diversification.
But the rise in correlations across several
bond types in 2020 illustrates the complexity
involved in building a diversified portfolio
using bonds. Not only are correlations constantly
shifting, but they also often rise during
periods of market volatility.

Even so, the basic arguments in favor of portfolio
diversification still hold. A diversified portfolio
reduced volatility and limited losses during
the market downturn in early 2020, albeit maybe
not as much as investors would have hoped.
Diversification also looks better over longer periods.
While diversification doesn't work with every
asset class in every market, it's still an important
tool for improving risk-adjusted returns over
the long haul-and bonds remain an important
part of that toolkit. K
Christine Benz is Morningstar's director of personal finance.
Amy C. Arnott, CFA, is a portfolio strategist with Morningstar.

Morningstar - Q2 2021

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