Why Is My Bond Fund Pulling in Its Horns?
A familiar problem has many managers taking risk off the table.
Numerous managers that we cover have expressed difficulty finding bonds with attractive valuations. With the exception of a few market sell-offs in recent years that made prices more attractive for a bit, that’s an issue that has become more and more pronounced as investors have snapped up bonds with attractive yields, driving up their prices. After backing up during the 18 months prior to 2016, for example, yield premiums (as measured by option-adjusted spreads) for bonds in the Bloomberg Barclays Investment Grade Corporate Index have since ground down to an average of less than 90 basis points at the end of 2017, from nearly double that level a year earlier. That’s especially notable given that the index’s last flirtation with a figure that modest was in February 2007, at the leading edge of the financial crisis.
And not unlike the later years of previous credit cycles, fund managers have also taken note of deterioration in the standards that corporate borrowers are being held to when setting the terms of their bonds and loans. That often means bank loans pledged with the security of second liens, in contrast to the most secured status leveraged bank loans normally carry.
Perhaps even more nerve-wracking is the fact that leverage among corporate borrowers has drifted up near historical highs, with average net leverage ratios of more than 2.3 times, metrics that are skewed by a growing portion of companies in the investment-grade universe—as many as 30%—carrying leverage ratios well above 3:1 (according to J.P. Morgan and TCW).
All of that translates to an environment that looks something like a coiled spring, such that a meaningful disturbance could have the potential to push borrowers into financial trouble, and bond investors to run from risk. Even events that might otherwise appear to be positive indicators—such as the Fed’s moves to raise short-term interest rates on the heels of a healthy economy—could carry the seeds of the next credit stumble. Leveraged companies whose debt payments are tied to floating interest rates are much more vulnerable to rising interest costs than they were back when Libor was at historical lows.
We haven’t heard many managers predict near-term problems in credit, and history suggests that the kind of benign conditions of today’s market can sometimes allow for dangers to build for longer stretches than seem sustainable. We arguably lack the more obvious signs of risk the market carried when extremes in the oil market a few years ago led to frenzied borrowing activity that looked plainly dangerous, for example, or the massive amount of lending before the financial crisis to homebuyers without sufficient incomes to cover their mortgage payments over the long haul. It therefore wouldn’t be surprising to see the market’s next big credit sell-off come as a result of something that might otherwise today seem benign. That’s all the more reason it seems prudent for managers to be building more caution.
Taking Chips Off the Table
Such managerial caution is by no means universal: There are still numerous funds that continue to assume meaningful credit risk in their efforts to keep income coming in the door and flowing out to shareholders. Plenty in the intermediate-term bond Morningstar Category, for example, still have north of 15% in bonds rated below investment-grade. They recently included the $12 billion JPMorgan Core Plus Bond (ONIAX), for example, with more than 22% in below-investment-grade rated and nonrated exposure at the end of 2017, and the $22 billion Western Asset Core Plus Bond (WACPX), with 16% in those credit strata at year-end. (The figures for both funds reflect modest exposure to legacy nonagency mortgages, some of which were never re-rated after the financial crisis despite their improved fundamentals.)
We know plenty of managers who are becoming more anxious about buying richly priced bonds as the months tick by, though. PIMCO Income (PIMIX), for example, has described its response to tightening credit spreads as a “de-risking”, and the fund raised its government exposure as a portion of its duration to half at the end of 2017 from less than one tenth one year ago, while cutting its emerging-markets duration weighting to less than one fifth, from nearly one third in May 2017.
A broader, if less precise, indicator that managers are becoming skeptical about the potential for high future returns among credit-sensitive bonds may be a trend in the nontraditional bond category. That group houses many funds that market themselves as being able to sidestep risk, and by definition, they boast extremely broad flexibility to maintain a lot—or very little—credit risk and sector concentrations.
Nonetheless, the group has long been characterized by its members’ heavy emphasis on credit. That exposure has moved around but otherwise been the norm overall for several years (often as a way to try and make up for the return costs of keeping below-market levels of interest-rate risk) and it shows in the category’s very high level of correlation history with high-yield and leveraged bank-loan indexes, in particular.
That’s noteworthy given the recent if modest trend of trimming those risks. After a long climb to a mid-2016 average of 46% in below-investment-grade and nonrated exposure from 25% in the third quarter of 2011, that figure drifted down to 41% by the end of 2017.
It’s worth pointing out again, though, that at those levels nontraditional bond funds still carry plenty of credit-market risk. Meanwhile, history suggests the likelihood that many managers will be able to swiftly jettison such exposures in time to save them in a bad credit sell-off is low.
Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.