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Rethink Your Bond-Fund Ballast Portfolio Matters | Christine Benz

to move down, and Federal Reserve officials have been telegraphing signals that they might soon begin tapering the Fed’s extended bond-buying program— which has buoyed bond prices while pushing down on yields. Bond market participants have attempted to get ahead of Fed actions, selling Treasuries and other rate-sensitive bonds and pushing up their yields. The yield on the 10 -year Treasury hit 2 . 823% on Aug. 15 , its highest level in two years. With the strong possibil- ity of more bond market trouble to come, it’s hard to blame investors for selling some of the categories they’ve been dumping. Meanwhile, rising rates are often the outgrowth of an improving economy, so investors’ embrace of credit-sensitive bond funds isn’t unreasonable, either. Floating-rate, or bank-loan, funds, a formerly niche investment type that has seen a whopping $ 54 billion in new asset inflows over the past year through August, appear especially well-poised to benefit from an economic environment that features rising bond yields and improving growth. The fact that the interest rates on floating-rate loans reset along with prevail- ing market yields gives them shelter from rising rates, something other bond categories do not offer. If eco- nomic growth picks up, loan-default rates will drop. Rethink Your Ballast Yet even as investors’ recent bond preferences make sense, they could take them too far, thereby limit- ing the diversification in their portfolios. And, in turn, they could negate the key reason most of us hold bonds—to have fairly liquid assets we could tap in a pinch when the rest of our portfolios are down in the dumps. That’s because the credit-sensitive bonds that inves- tors have recently been buying have historically had a much higher correlation with stocks than the high- quality bonds they’ve been selling. That relationship was on stark display during the recent bear market, when some high-yield and bank-loan funds posted losses in line with equity funds. That might not be prudent, in the view of Bob Johnson, Morningstar’s director of economic analysis. “Inter- mediate term, I think the economy is fine, but not the

The Federal Reserve surprised almost everyone when it pushed back its tapering of bond purchases. The news was warmly received in the stock market, but bond investors are still feeling indigestion. The average intermediate-bond fund is down about 2% for the year to date through October, and long- term bonds and Treasury Inflation-Protected Securi- ties funds are down 4% and 6% , respectively. As a result, we saw a huge outflow from taxable-bond funds over the summer. All told, investors with- drew about $ 60 billion from June through August. The May-July interest-rate tremor sent investors scrambling out of rate-sensitive bonds. Government- bond funds—including those focusing on TIPS and GNMA s—got the heave-ho. So did a lot of core inter- mediate-term bond funds like PIMCO Total Return PTTRX . But offsetting outflows in these groups were strong inflows into other fixed-income categories, including non-traditional-bond funds like PIMCO Uncon- strained Bond PUBDX , and the hot category of the moment, bank-loan, or floating-rate, funds. Investors appear to be trading interest-rate risk for another type of risk—credit risk. The risk, however, is that by jettisoning high-quality bonds in favor of more credit-sensitive ones, they’re throwing out their portfolios’ ballast—investments that may hold up well when stocks do not. And in the process, their portfolios are tacitly banking on one type of outcome—a sustained economic recovery— while ruling out the possibility that there will be setbacks along the way. Not Entirely Irrational In many respects, investors’ recent preferences make a lot of sense. Interest rates don’t have a lot of room

Welcome to our new feature, Portfolio Matters, by Christine Benz, Morningstar’s director of personal finance. We’re thrilled to have Christine help you manage the port- folio challenges that you face each month.Christine will address personal finance issues with prac- tical solutions through- out the year.