Morningstar - Q4 2020 - 18

Dispatches

something of a retail pioneer back then, and
benchmark-driven duration management,
previously the province of institutional managers,
swept the fund industry. That style has
become enshrined in the canon, and there has
seemed little reason to question it.
Most core bond funds use the Bloomberg Barclays
U.S. Aggregate Bond Index or similar highquality indexes as benchmarks for "the market."
Until the 2008 global financial crisis, the highquality U.S. bond market's overall duration
had almost always ranged in the neighborhood
of 4 to 5 years-for decades. However, this
market began to slowly morph after the crisis,
and today its duration is at 6 years.
As the Trend on the previous page illustrates, the
Treasury and investment-grade corporate sectors
have grown at a much faster pace than the
agency mortgage sector. That's a big deal because
mortgages have always played a moderating
role. Their amortizing structures-and prepayments
from homeowner refinancing-usually keep
their durations shorter than those of the other
two sectors. As those markets ballooned,
mortgages became less effective as a check on
the overall market's rate sensitivity.
The Treasury and corporate markets also underwent
a fundamental change that turbocharged the
impact of their growth on the market's overall
duration: If the Treasury and high-grade companies
were going to ramp up borrowing in the
trillions of dollars, they were certainly going to
take advantage of low rates at the long end
of the market and give themselves plenty of time
to pay back the debt.
These changes raise a question of whether
anchoring bond portfolios to marketlike
benchmarks makes as much sense when their
durations are 6 years or longer. Today, a
100-basis-point upward yield shift can lose you
6% or 6.5%. When core benchmarks had
a shorter duration, the same shift used to mean
a 4% to 5% drawdown.
That's not the same thing as asking whether
investors should ditch benchmarking and dive into
unconstrained strategies. The market's extension

Morningstar Q4 2020

hasn't done anything to change the fact that
making interest-rate calls is as hard as it's ever
been. It does pull back the curtain on an issue that
has rarely mattered much to the high-grade bond
market, though, and that's whether sticking
faithfully to broad, market-weighted benchmarks
makes sense in all environments.
Should the underlying risk of a shareholder's
bond portfolio be inextricably tied to explosive
government and corporate borrowing and
the decisions those actors make, driven by their
interests rather than the shareholder's?
Might the shareholder be better off with
a benchmark that still holds those sectors but
puts more emphasis back on mortgages,
or maybe less concentration in the longest of
long-maturity, low-coupon debt?
There's no easy answer. We can back-test
alternatives with different weightings
and compositions, but the market is now in such
uncharted territory that we don't know if
the next 30 years will look anything like the last.
Either way, the industry isn't likely to address
those questions anytime soon. Asset managers
have always said that they choose broadly
based, market-weighted benchmarks with strong
investor recognition because that's what the
SEC wants. Under that regime, investment-grade,
market-value-weighted benchmarks are used
by nearly every core bond fund, and any efforts
to move away from them, even if only to some
modified version, are likely to be a slog. Wellknown managers with a strong following might be
able to pull it off, but it's hard to imagine that
happening in more than a few cases. Plenty
of managers thought rates were unsustainably
low after the global financial crisis, took a
stand by underweighting duration, and then saw
their relative returns suffer. It would take
even greater conviction to switch benchmarks
now and risk falling behind their peers again.
Assuming bond markets continue to carry a similar
profile, core bond funds will continue to be
drawn into greater interest-rate sensitivity-and
volatility. That's by no means an argument to
drop them. When portfolios heavy with stocks and
other risky assets run into trouble, high-quality

bonds with a healthy dose of duration are
usually the only ballast. You can see that in the
histories of unconstrained funds that built
their strategies around slashing interest-rate risk in
favor of credit risk and had nowhere to hide
when risky assets crashed. Mixing core funds with
shorter-maturity, high-quality portfolios might
be just one of many options for coping with the
market's new reality.
Eric Jacobson is a manager research strategist
with Morningstar.

Leave Clorox on
the Shelf
Clorox CLX has closed the books on a bang-up
fiscal 2020, underpinned by considerable sales and
profit gains. Its business has evidenced resiliency
throughout economic cycles, and its stock
has been on a tear, up more than 40% for the year
through September, far exceeding the 5% gain
of the Morningstar US Consumer Defensive Index
over the same horizon.
We don't expect this pace will be sustained longer
term. Consumers have favored Clorox's cleaning
and disinfectant products since the onset of
COVID-19, but this is unlikely to hold as concerns
surrounding the virus fade, particularly if a vaccine
comes to market by mid-2021 as we expect.
Further, a few slices within Clorox's mix were under
intense competitive pressure from lower-priced
private-label and other branded offerings before the
pandemic, and we don't think the current backdrop
has changed this. Also, Clorox has struggled to
meet the outsize demand caused by the pandemic.
We expect the firm will spend more to increase
its manufacturing capacity, which we view as
prudent (and necessary) if done at a measured pace.
Added logistics, maintenance, safety, and labor
costs, combined with further investments behind
the company's brands (in the form of research
and development as well as marketing), should also
constrain near-term margins, even if volume
leverage persists over the next few quarters. When
taken together, we view the current share price

Morningstar - Q4 2020

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