With a historic amount of assets shifting between asset management firms, many retirement plan advisers and plan sponsors are re-examining their bond investing strategies. Just about every plan participant has an allocation to core bonds, which are often used to diversify away from equities.
But in a study that we conducted, we noticed a worrisome trend. In an effort to boost returns, nearly 40% of the funds in Morningstar's intermediate-term-bond category have drifted toward a level of high-yield exposure that could dilute the diversification benefits of a traditional core-bond strategy.
It is important for plan sponsors and advisers to be aware that core bond strategies differ significantly. Knowing the distinctions among the funds and to be able to identify the right attributes when selecting a style-pure core-bond strategy makes it possible to avoid taking on unintended exposure to high-yield debt.
Core-bond strategies are typically the base camp of fixed-income investments. True core-bond strategies generally have less than 10% of their assets in high-yield bonds.
Our research revealed that a significant number of funds in Morningstar's intermediate-term-bond category — the largest of the fixed-income categories, containing more than 300 funds and around $1 trillion in assets — have been increasing their exposure to high-yield debt. This supplemental use of below-investment-grade securities is a legitimate way of allocating portfolio risk. But it can transform a core-bond strategy into a core-plus strategy that acts more like high yield than anticipated.
RISK AND RETURN
It stands to reason that adding high-yield bonds may increase a portfolio's expected return over time, but at what level of incremental risk? Importantly, is that exposure to high yield already present in the participant's portfolio through other intentionally selected allocations to high yield?
Using a core-plus strategy as a stand-in for a core-bond allocation could unintentionally amplify an investor's exposure to high yield.
As part of the study, we identified dozens of funds with significant allocations to below-investment-grade debt. All funds holding 10% or more in debt rated BB and below with at least 10 years of performance data as of Sept. 30, 2014, were sorted into a category labeled the core-plus composite.
As anticipated, the core-plus composite had a much stronger positive correlation with the S&P 500 (representing the equities market) than with either the
Barclays U.S. Aggregate Bond Index (representing a style-pure core-bond allocation) or the
Barclays U.S. Treasury Index. Correlation of these funds with the S&P 500 came in at 0.31 compared with a -0.36 correlation of the Aggregate Bond Index, providing quantitative support that junk bonds tend to behave more like equities than traditional core bonds do.
From Jan. 1, 2000, through Sept. 30, 2014, the UST Index had a correlation with the S&P 500 of -0.69, demonstrating significant negative correlation. The aggregate bond index also provided a negative correlation with the S&P 500 of -0.36. However, the
Barclays U.S. Corporate High Yield Index had a positive correlation of 0.73.
We found that the volatility of the high-yield index is nearly three times the volatility of the aggregate index. Additionally, the Sharpe ratios strongly demonstrate the differences in the return-to-risk profiles of the asset classes since 2000. The core- bond space as represented by the aggregate index has demonstrated a much more constrained level of risk and a significantly higher Sharpe ratio than have high yield and equities. These return figures will certainly evolve over time as we put the financial crisis of 2008 further behind us, but nonetheless, it is important to note the significant differences in risk between the investment-grade and below-investment-grade asset classes.
TRUE EXPOSURE
Plans seeking true exposure to the core-bond asset class should avoid selecting a strategy that deviates from those style-pure characteristics. It's important to appreciate that as credit quality decreases, diversification benefits of investment-grade core bonds may diminish.
Additionally, the volatility-dampening effect of core bonds to equities also may decline with greater exposure to high yield. If the intention is to provide retirement plan participants access to a core bond fund that has limited exposure to high yield, look for a strategy that stays true to its style of investing.
Aldo Ceccarelli is head of investments at Wells Fargo Funds Management.
