(PUB) Morningstar FundInvestor

February 2 014

Morningstar FundInvestor

17

and when yields pop up. Funds, meanwhile, have bonds maturing all the time and therefore have the option to trade into higher-yielding securities as they become available, even though they may take a hit to their principal values as yields rise. And although buying individual government bonds or corp- orate bonds issued by AAA rated companies is a reasonably safe strategy, smaller investors venturing beyond gilt-edged bonds may have trouble conduct- ing adequate research on such credits and assembling a portfolio with adequate diversification. Trading costs also can be an issue for small investors. Tilting Toward Credit Sensitivity The Strategy: Another tack bond investors have been taking lately has been to venture into more credit- sensitive bond types in lieu of higher-quality fixed- income funds. Bank-loan, unconstrained bond, and, to a lesser extent, high-yield bond funds have been seeing massive new inflows, even as investors have hit the exits at traditional core bond funds such as PIMCO Total Return PTTRX . Credit-sensitive bonds have higher yields attached to them than higher- quality bonds, and that yield provides a better cushion in a period of rising rates than high-quality bonds. Bank-loan funds have an additional level of impervi- ousness in a period of rising rates, in that their yields adjust upward to keep pace with prevailing rates. Buyers of lower-quality credits also can take comfort in the fact that the economy seems to be recovering, so broad-scale defaults are unlikely. The Risks: Even though it’s not unreasonable to assume that the economy will continue to mend, and that will serve as a positive for lower-quality credits, there’s always the risk that the economy could experi- ence a hiccup or worse, which would tend to depress the prices of lower-quality bonds. And while such bonds typically offer higher yields than higher-quality credits, that yield differential has narrowed consider- ably over the past few years. For example, the yield spread between the Bank of America Merrill Lynch High Yield Index and Treasuries was recently 3 . 92% — not as low as it got in late 2007 (about 2 . 5% ) but cer- tainly low relative to historic norms. Perhaps an even bigger issue is that lower-quality bonds may not

fulfill one of the key roles investors look for bonds to fill: diversification.

Buying Dividend-Paying Stocks The Strategy: With bond yields as depressed as they’ve been, dividend-paying stocks have emerged as a compelling alternative for many investors, offering yields that are competitive with or in some cases higher than high-quality bond yields. Right now, for example, the yield on the Barclays Aggregate Bond Index is just about 25 basis points higher than that of the S & P 500 , and it’s not hard to find high- quality companies with yields that are much higher than the S & P’s. Investors in dividend-paying stocks can also benefit through share-price appreciation and if companies increase their dividends. The Risks: The biggest drawback to using income- producing equities to supplant fixed-income securities is volatility. The median equity fund with a dividend focus has a five-year standard deviation of about 15 , whereas the typical intermediate-term bond fund has a standard deviation of just 3 . Long-term dividend- focused investors might say they’re unperturbed by short-term volatility, but if they’re relying on their port- folios for dividend income and their payouts and/or emergency funds don’t cover an unplanned expense, they could be forced to raid their principal when it’s at a low ebb. Moreover, while income-producing stocks aren’t as directly affected by interest-rate changes as are bonds, they’re not impervious, either. The past summer’s interest-rate shocks caused shudders across a host of income-producing equity sectors, especially utilities. œ Contact Christine Benz at christine.benz@morningstar.com