Carefully selected bond funds as part of a diversified asset mix
If you haven’t checked your portfolio for a while, you may have noticed that the performance of your bond mutual funds and ETFs has been lagging a bit. And you may be thinking of selling or switching. But before you do, think about how bonds are priced and the purpose they serve in a portfolio. While bonds are the classic defensive investment, and should generally be a part of a well-diversified portfolio as an asset class that is uncorrelated to equities, their prices react directly to the prevailing level of interest rates.
As interest rates rise, bond prices decline. This inverse movement is a result of the relationship between a bond’s price and its stated “coupon rate.” Bonds are priced on the open market so that their “yield” (basically, a bond’s stated coupon rate divided by its current price) remains competitive with yields of instruments of comparable quality and term. So, for example, if high-yield corporate bonds yield, say, 4%, a bond with a stated coupon rate of, say, 3.5%, would be priced around $89 per $100 of face value, a discount of $11 from par (a bond’s face value), so that it yields about 4%.
When rates rise, bond prices decline, shrinking the value of bond holdings in a portfolio, whether individual bond holdings or a mutual fund, pool, or exchange-trade fund. And this is precisely the problem bond funds have been facing recently.
As central banks normalize monetary policy, they remove the so-called quantitative easing put in place after the 2008 financial crisis, and raise policy rates. Both the Bank of Canada and the U.S. Federal Reserve Board have been raising their benchmark rates from historic lows, in steady increments of 25 basis points since about the end of 2016.
That has put steady downward pressure on bond prices, leading some pundits to predict a bond bear market. For individual bond holders, this does indeed present a problem. But active bond fund managers have a number of techniques they use to deal with the uncertainties of interest rate movements. They can adjust the average term to maturity of their portfolio (shorter-term bonds tend to be less volatile than longer-term issues). They may adjust something called “duration” (a measure of how many years it would take to repay the price of a bond from internal cash flow) – the higher the duration, the greater the risk. In high yield funds, which tend to hold corporate bonds, they could also tinker with quality, defensively increasing the number of BBB-rated bonds, for example, while reducing the number of lower-rated issues and increasing cash.
For investors seeking to rebalance portfolios that already include bond mutual funds or ETFs, it makes sense to research some of the performance and risk metrics for funds before making a decision. First of all, look at a fund’s standard deviation, which a common measure of a fund’s variability of return from its long-term average. The higher the standard deviation, the more volatile, or riskier, the fund is.
Another good clue to the quality of the fund, and thus a place to begin your research, is with the Fundata FundGrade ranking. This is an entirely objective monthly quantitative measurement developed by Fundata Canada Inc. that ranks investment funds from a top grade of “A” to a low grade of “E.” I like the FundGrade rating, which also rates ETFs, because there’s no confusion about what it is. The analytic brains at Fundata have stripped out any subjective element in the calculation (for example, there is no subjective assessment for a specific manager’s “value added” and the like). Basically, what you get is an honest one-letter answer to the question: “Did this fund deliver?”
These steps should be among the first for your research into bond ETFs and mutual funds as potential investment candidates to buy, sell, or switch into. To properly place such investments into your overall portfolio and ensure you’re meeting your financial targets within your risk-tolerance, it’s always best to consult with your investment advisor or financial planner.
© 2018 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.