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Investing Specialists

The Error-Proof Portfolio: Is Your 'Balanced' Fund Binging on Junk Bonds?

Some supposedly staid allocation funds have ventured down the credit-quality ladder.

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Allocation funds--sometimes called balanced funds--are the workhorses in many investors' portfolios.

Combining stocks and bonds, they aim to provide investors with a well-diversified package in a single shot and can reduce the need for a lot of hands-on oversight. Such funds are typically rebalanced back to a target stock/bond mix so investors don't need to get their hands dirty making allocation changes. And because the equity portion of the portfolio often thrives when the bond piece is struggling, and vice versa, the funds' returns often chart a steady course. That makes them easy to own: Morningstar's various allocation categories (as well as target-date funds, which employ a similar concept) often have among the most impressive investor returns of any fund type.

Yet, with high-quality bond yields ultra low, some allocation funds have assumed an aggressive posture with the fixed-income component of their portfolios. A small subset of allocation funds (including some high-profile offerings such as  Vanguard Wellesley Income (VWINX)) currently have durations longer than the Barclays Aggregate Bond Index's. A much larger contingent of allocation funds have ventured down the credit-quality ladder. That positioning may serve to bump up their yields, and favoring lower credit qualities has certainly been well rewarded since the bear market. The trade-off of favoring junky bonds, however, is that the fixed-income component of these funds' portfolios may not deliver in the clutch, when equities are falling. Indeed, a high percentage of the funds with low-quality portfolios today also posted above-average losses during the 2008 stock-market rout.

A Taste for Lower Quality
Given that interest rates have much more room to move up than they do down, and that rising rates would be apt to hit longer-duration bonds harder than short-duration ones, it's not too surprising that very few allocation funds are maintaining long durations right now. Just 11% of conservative-allocation funds (which stake the lion's share of their portfolios in bonds and smaller positions in stocks) currently have durations greater than the Barclays Aggregate Bond Index; slightly higher percentages of funds in the moderate- and aggressive-allocation groups--15% and 14%, respectively--do so.

Instead, it appears that more allocation-fund managers have a greater comfort level taking credit-quality risk at this juncture. Forty-two percent of the funds in Morningstar's largest allocation category--moderate allocation--had average credit qualities of BB or below (a junk bond rating) as of their most recently available portfolios. And more than half of the funds in both the conservative- and aggressive-allocation categories currently have average credit qualities at or below BB. The funds with lower-quality bond portfolios include such widely owned offerings as  Franklin Income (FKINX),  Principal Global Diversified Income (PGBAX), and  American Funds Income Fund of America (AMECX). (The latter fund has steered a fairly small share of its assets to bonds in recent years, however.)

A Mixed Picture
There's no doubt that venturing into lower-rated credits has been a boon to many of these funds over the past five years. In all three allocation categories--aggressive, moderate, and conservative--the subset of funds with average credit qualities at or below BB had a higher median five-year annualized return than the subset of funds with credit qualities higher than BB. Delving into lower-rated credits was a particular boon to the conservative-allocation funds that did so. Over the past five years, the median annualized return for conservative-allocation funds with credit ratings of BB or lower was 8.5%, versus a 7.2% annualized gain for funds with credit ratings of BBB or better. Given that conservative-allocation funds have a higher percentage of bonds than the other allocation categories, it stands to reason that the composition of their bond portfolios would be a bigger swing factor in returns than in the more stock-heavy allocation categories.

It's also true that the fundamentals for high-yield bonds remain strong, with defaults remaining under 2% over the past few quarters--very low by historical norms. Perhaps more worrisome is that strong demand for junk bonds has driven yield spreads--the yield differential between junk bonds and Treasuries--to very low levels relative to where they've been historically. From a practical standpoint, shrinking yields give high-yield bonds less room for error, because their yields don't provide as much of a cushion as they once did. But that doesn't mean a rout in high-yield bonds is imminent. In fact, Dave Sekera, Morningstar's director of corporate bond strategy, recently argued that high-yield bonds should hold up better than high-quality corporate bonds in the intermediate term if interest rates rise and the economy continues to improve.

The real concern, however, is that if stocks falter, many of the allocation portfolios with low credit qualities would be likely to fall further than their higher-quality counterparts. Part of the thesis behind owning an allocation fund--or allocating your assets across stocks and bonds, period--is that when the equity piece of the portfolio is falling, the bond component should hold its ground, or even rise.

But the correlations between low-quality bonds and equities is much higher than is the case for high-quality bonds and stock, as discussed in this article. Thus, it's probably not surprising that within the aggressive-, moderate-, and conservative-allocation categories, the subset of funds that have below-investment-grade average credit qualities today also have higher 10-year standard deviations than their higher-quality counterparts. The low-quality groups also posted steeper losses than their higher-quality peers in 2008. The performance differential was particularly pronounced in the conservative- and aggressive-allocation groups: In both categories, the lower-quality cohort lost four percentage points more than the higher-quality group amid 2008's equity-market rout.

That's not to suggest that investors should reflexively run away from allocation funds with low average credit qualities. That positioning has served many such funds well over the past five years, and in some cases over longer periods, too. It's also possible that these funds' managers could lighten up on low-quality bonds at some point in the future, thereby, protecting their charges on the downside.

Seeing so much low-quality exposure in so many allocation funds is, however, a reminder to know what you own and periodically revisit your funds' positioning. If you own an allocation fund in an effort to obtain diversified stock/bond exposure, you may not be getting it if your allocation fund's bond exposure is too equitylike. The aggressive fixed-income position is arguably the most worrisome in the realm of conservative-allocation funds, where investors might assume that a mild risk/reward profile would be the natural outgrowth of holding a limited equity stake.

Moreover, if you're one of the many investors who has added high-yield bond exposure to your portfolio over the past few years, you may have inadvertently doubled up on junk-bond exposure if your allocation manager was simultaneously steering the portfolio in that direction. Ditto, if you've added a general fixed-income fund, such as  PIMCO Income (PONAX) or  Loomis Sayles Bond (LSBRX), with the latitude to invest heavily in lower-quality corporate bonds.

See More Articles by Christine Benz

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.