Bond Market Risks: Keeping It Short, Simple, and Safe

A recurring theme in my asset allocation philosophy is to stick with simple and safe bonds in your portfolio. The problem is, there will be other bonds that outperform safe, shorter-term US Treasury bonds and you might start to question your decision. I try to remind myself to consider how they fit into your entire portfolio. I would rather take on risk with stocks due to their big upside potential and use bonds for stability in times of stress.

Here is an older WSJ article The Case for Minimizing Risk in Your Bond Holdings by William Bernstein on the subject. If you run into a paywall, I discuss the article here.

Recently, there have been more articles about the riskier bond options out there.

Corporate bonds – hidden risks? Credit ratings agencies continue to have the conflict of interest where they are paid by the bond issuers themselves – remember the financial crisis and those AAA-rated subprime bonds? These days, companies are loading up on debt, but they still really really really want their bonds to be rated as “investment-grade”. More than 50% of the corporate bond market is now rated BBB, just barely “investment grade” as opposed to “junk”, according to the Bloomberg article A $1 Trillion Powder Keg Threatens the Corporate Bond Market:

That’s a lot of borderline debt that will eventually have to be refinanced at higher rates.

Actively-managed bond funds – what’s really inside? In addition, I recommend reading this Forbes interview with bond manager Jeffrey Gundlach: The Bond King Speaks: Doubleline CEO Jeffrey Gundlach Offers His Best Investing Advice. There are many interesting insights, and here are some excerpts on bond index funds and the active bond fund competition:

On the fixed-income side, active bond managers have by and large outperformed the intermediate-term bond benchmark, the Barclays Bloomberg Aggregate Bond Index (the “Agg”).

What helps the active manager to outperform the index is that it’s quite possible in bonds to do things very differently from what’s in the traditional bond indexes. The Agg has no foreign bonds, certainly no emerging markets bonds, no below-investment-grade bonds, no bank loans, no structured finance to speak of like ABS or CMBS, all of which are viable asset classes. But the index doesn’t include them. Active bond managers can buy these things and increasingly over the last couple of decades have done so.

Active funds are being measured against an investment-grade U.S.-only index. The active funds can own tons of emerging markets, junk bonds, bank loans — some of them even own 10 or 15% equities. Obviously, if a manager is allowed to own equities against the bond index in a world where bond returns over the last two years are nearly zero on a total return basis, you can see there’s a lot of ways that bond managers can game an index more than a stock manager.

Is a stock manager really going to measure themselves against the S&P 500 and own 50% bonds? I doubt it. The industry’s evolved in a way that has given us an advantage.

That’s probably going to turn into the opposite soon, where these activities outside of the boundaries of U.S.-only, intermediate-grade only bonds will start hurting. Junk bonds are getting crushed. Investment-grade corporate bonds are doing horribly over the last year. Typically, these are systematically overweighted by the majority of active bond managers. Not us, not Doubleline.

You could categorize the industry fairly accurately with a broad stroke by saying most firms are perpetually overweight corporate credit, underweight treasuries and they even have some stocks with below-investment-grade ratings. When you get to a world where the lower quality material like junk bonds or emerging markets are starting to come under stress due to falling equity prices, and perhaps a slowing global economy, well, suddenly, these games that are often played don’t help.

As noted recently, Total Bond ETFs that track the AGG index have 60-80% of their holdings that are backed by the US government, and the rest are investment grade US corporate bonds. Overall it is mostly high-quality stuff. Meanwhile, an actively-managed bond fund can include riskier corporate bonds, complex asset-based securities, or bonds from Emerging Markets countries with much higher yields. Basically, bond managers can take on a lot of extra risk and get paid for it while the party lasts. This will make them look like they are beating the AGG benchmark, while their holdings are nothing like the benchmark.

With actively-managed bond funds, it’s always a question of the manager adding enough value to compensate for the higher expenses. Bill Gross used the be “Bond King”. Now it’s Gundlach. Maybe Gundlach will continue to successfully time his purchases in and out of various bonds. I choose not to depend on a specific manager’s skill. Instead, I stick with US Treasury bonds, investment-grade municipal bonds from a conservative bond manager, or FDIC-insured bank certificates of deposit for the bond portion of my portfolio.

“The editorial content here is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are the author’s alone.”

Bond Market Risks: Keeping It Short, Simple, and Safe from My Money Blog.

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