If the direction of asset flows out of stock funds and into bond funds this year is any kind of guide, investors are seeking shelter and yield in fixed income. But they could be getting neither.
Through the end of June, U.S. equity mutual funds experienced $56.2 billion worth of net outflows, while U.S. bond funds added $73.5 billion in net inflows.
The asset flows, based on Morningstar data, show a sharp swing from the full 12 months of last year when equity funds had $5.9 billion in net inflows, and bond funds had net outflows of $21.2 billion.
With the equity markets hovering around record highs, the direction of assets flows is understandable.
But what some financial advisers and investors might not be fully thinking through is
how much risk they're actually taking on in the fixed-income side of the portfolio.
“The big challenge for advisers is to know what you're putting your clients into when it comes to bond funds, because you have to make sure you're overlapping credit risk with interest-rate risk,” said Dan Heckman, senior fixed income strategist at
U.S. Bank Wealth Management.
K.C. Nelson, who manages $3 billion worth of fixed-income portfolios at Driehaus Capital Management, said bond fund investors who aren't careful could be hit hard by an interest rate hike, or just hit less hard by continued low rates.
“Investors are drawn to bonds because they're afraid of all the macro risks out there, and they also believe interest rates are not going up anytime soon, but they're making a mistake by looking in the rearview mirror at the performance of bonds,” he said.
When interest rates were at more normalized levels,
diversification across the fixed-income spectrum was more straight forward, and could be accomplished through a blend of corporate, municipal, government bonds, and mortgage-backed strategies.
But with the
Federal Reserve setting its overnight rate at 0.25% and the 10-year Treasury yielding just 1.5%, the bond world has essentially morphed into a singular blob of rate-risk.
Consider, for example, the various correlations to the SPDR
Barclays Intermediate Term Treasury ETF (ITE).
The Treasury ETF has a 0.85 correlation to both the iShares
Barclays Aggregate Bond ETF (AGG) and the DoubleLine Total Return Bond Fund (DBLTX), and a 0.81 correlation to the commercial mortgage backed securities ETF, iShares CMBS (CMBS).
Considering 1 represents full correlation, the Treasury ETF is only slightly less pegged than the iShares iBoxx Investment Grade Corporate Bonds (LQD), with a correlation of 0.73; and iShares S&P National AMT-Free Municipal Bonds (MUB), at 0.71.
Unlike the so-called risk-free rate of a Treasury bond, which is based on the credit quality of the United States, corporate and municipal bond risk is pegged to a combination of interest rates and the credit quality of the issuer.
And, as Mr. Nelson explained, the lower the level of interest rates, the higher the sensitivity bonds become to interest rate movements.
“Bond strategies are all becoming more correlated, and investors have a false sense of security that they're diversified based on the labels of the funds,” he said. “But it's not diversification; it's just owning U.S. interest-rate risk in different forms.”
Mr. Nelson thinks advisers and investors should diversify the rate risk in fixed-income allocations by allocating to strategies more heavily exposed to credit risk, such as bank-loan funds, foreign-sovereign bonds or nontraditional bond funds.
As correlations go, the bank-loan ETF, ProShares Senior Loan Portfolio (BKLN) has a 0.27 negative correlation to the Treasury ETF.
The Bloomberg Global Developed Sovereign Bond Index (BGSV) has a 0.52 correlation to the Treasury ETF, and the iShares iBoxx High Yield Corporate Bond ETF (HYG) has a negative correlation of 0.32.
The Driehaus Active Income Fund (LCMAX), managed by Mr. Nelson, has 0.36 negative correlation to the Treasury ETF.
While financial advisers would be wise to start diversifying their fixed income allocations beyond just strategies providing interest rate risk, even that presents its own set of challenges, according to Morningstar fixed-income analyst Sara Bush.
“Fixed-income diversification could come from more exposure to credit risk, but depending on how to do that you could be bringing in more equity-like risk,” she said. “It's challenging to diversify, because you have to be sensitive to the risk of just adding risk elsewhere.”
