A version of this article appeared in the August 2021 issue of Morningstar Fund Investor. Download a free copy of Investor Fund through site visit.
The yields are low. Rates are more likely to go up than to go down. Real returns are negative. By now, the fate of bond funds is well known, and for good reason. The lower the starting yields, the lower the yield investors can expect from their bonds in the future. It is a mathematical certainty.
This article will review the current state of four Morningstar bond categories: Short Term, Core Core, Core Plus, and Multi-Sector. These four categories represent the main categories of bonds, with other categories, such as ultra-short and high yield bonds, playing a supporting role. Since funds from one or more of the ‘big four’ are likely to form the core of an investor’s fixed income allocation, it is important to understand this allocation and set expectations appropriate to their investment. regard before layering the support products.
Let’s start by looking at the average SEC yield and average duration for each category. The SEC yield is a number that approximates the current average yield of all bonds in a given fund’s portfolio, which means that it is a reasonable starting point for evaluating expected returns. Duration is an estimate of the fund’s sensitivity to changes in interest rates.
As of August 2021, the average short-term bond fund had an SEC yield of 0.95% and a duration of 2.2 years. Meanwhile, the average core bond fund had a return of 1.21% and a duration of 5.9 years. This means that investors only capture 26 basis points of the expected return while almost tripling the risk associated with rising interest rates. Investors already got a taste of this risk in the first quarter of 2021, when the yield on the 10-year US Treasury bill rose 81 basis points. The average core bond fund lost almost 3% in the quarter, while the average short-term fund lost just 12 basis points.
What happens when we go from kernel to kernel plus? The average core-plus bond fund had an SEC yield of 1.70% and a duration of 5.7 years. Thus, the average rise in yield was 49 basis points against core bond funds, while the sensitivity to interest rates was slightly lower. The differences here are due to the categories’ different exposures to junk rated debt, with core bond funds capped at a maximum of 5%, while core plus bond funds can range from 5% to 25%. The additional credit risk drives up yields and insulates core-plus funds slightly from rate shocks – the average fund lost 2.6% in the first quarter of 2021 – but also exposes investors to drawdowns during tied mass selling credit as early 2020. In the depths of the coronavirus panic from February 20, 2020 to March 23, 2020, the average core-plus bond fund lost 6.2%, while the average core bond fund lost only 3.2% – a huge difference when you consider that the current returns and durations are not too dissimilar.
Finally, multi-sector bond funds assume the highest level of credit risk among the four major categories, which insulates them from most peaks in rates; the average multi-sector fund lost just 22 basis points in the first quarter of 2021, almost as good as the short-term average supply. But this has a downside, as multi-sector funds will certainly lag behind the other three categories during credit crises. During the COVID-19 panic in early 2020, the average multi-sector fund lost 14.1%, more than double the average loss of core-plus funds. While the average SEC return on multi-sector funds is about 100 basis points higher than the return on core-plus funds, investors must decide whether this offsets potential double-digit losses.
There is no quick fix for bond investors. Low returns force a decision: accept low returns or add additional returns to the risk of large losses when the tide turns. And obtaining protection against one type of risk, such as rising rates, usually means exposure to losses of another type, such as credit risk. The solution to this conundrum will be different depending on the requirements, expectations and risk tolerance of each investor.