Morningstar - Q2 2021 - 35

increased from 16% at the end of 2007 to 26%
as of February 2021), that more funds would
be inclined to increase their exposure to corporate
debt to reduce their tracking error. Yet, in a
world of rock-bottom yields both in securitized
debt and U.S. Treasuries, the slight premium
offered by corporate bonds most likely served as
a lure for many core bond managers.
As managers have piled into corporate bonds
for their higher yields, the resulting price
appreciation in the space helped drive yields
across the corporate bond market to record lows.
It isn't surprising that the yield of the ICE Bank
of America AAA Corporate Bond Index,
representing a sampling of the highest-rated
corporate bond issues, has consistently been lower
than that of the near speculative-grade BBB
index ( E X H IB IT 4 ). At the end of February, however,
the spread between the two was extremely
tight: The BBB index yielded 2.4%, whereas the
AAA index yielded only 40 basis points less
at 2.0%. These BBB rated corporate credits tend to
fall in value more sharply in credit shocks than
higher-rated corporates, but the yields are
so low that it may not be enough to compensate
investors for the risk that certain managers
have taken by concentrating heavily on
that segment of the credit market. A manager

concentrating heavily on BBB rated corporate
credit is not gaining a significant yield premium
to its steadier peers.

This is not to say that any core bond fund
posting an SEC yield higher than its peers is taking
on insurmountable interest-rate or credit
risk. When in doubt, it's worth digging into a
fund's holdings to ascertain where the managers
are taking on the greatest interest-rate and
credit risk-knowing these differences can be the
key between sailing through or sinking during
a market drawdown.

So, where are yields still elevated? The answer
may be uncomfortable for investors seeking
the relative safety of a core bond fund holding.
Only the riskiest parts of the fixed-income
market, including low-quality securitized fare,
high-yield corporate bonds, and leveraged loans,
are posting yields much higher than those
of the traditional investment-grade core-bond
sectors. As many investors were painfully
reminded in March 2020, these issues offer juicier
yields precisely because of their higher credit
risk, and broad indexes tracking these sectors fell
by up to double digits during the worst of
the sell-off. While the intermediate core bond
category sets a strict 5% limit on debt rated
BB and below, managers pushing to the limit of
this ceiling to gain a higher yield may be
putting their investors at risk.

As is always the case with fund investing,
shareholders ignore the price tags levied by their
investment managers at their peril. Given
that SEC yields are net of fees, a pertinent maxim
comes to mind: The higher the fees charged
by your fund manager, the greater risks they will
need to take to deliver the same level of yield
(and return) than a cheaper competitor.
While the world of fixed-income investing
has changed significantly over the past 15 years,
the advice we give to the fixed-income fund
investor remains the same: If a fund's yield looks
too good to be true, it probably is. There is
no free lunch in bond fund investing, and investors
today must accept that higher yields mean
higher risk. A core bond fund that advertises a
far higher yield than its index or peers may be
employing tactics such as going long on duration
or low on the credit-quality spectrum; those
doing so with a middling to heavy price tag might
be using even riskier methods.

Where Do We Go From Here?
Part of the job of the core bond manager has
always been balancing attractive yields
without too much credit or interest-rate risk. With
yields as low as they are across the fixedincome market, this job is harder than ever for
even the most seasoned investor.

6

Low yields in the broad fixed-income market
mean that, all else being equal, core bond fund
investors are likely to earn a lower yield and
return on their bond portfolio than they have in the
past. Investors with long time horizons who
want an extra yield boost to meet their goals may
decide to accept more risk with allocations
to junk-rated corporates or even equities. Those
investors who want to avoid adding risk
would be better served sticking with conservative
bond funds that sport experienced teams,
sensible investment processes, and low fees. K

3

Gabriel Denis is a manager research analyst
with Morningstar Research Services LLC.

EXHIBIT 4

Tighter Spread in Corporates The difference in yields between AAA and BBB rated
bonds has narrowed.
Effective Yield of ICE Indexes
ICE BofA AAA US Corporate Index

ICE BofA BBB US Corporate Index
12%
9

2.37
1.97
01/02/2008

01/02/2011

01/02/2014

01/02/2017

0

02/28/2021

Source: Morningstar. Data as of 02/28/2021.

morningstar.com/lp/magazine

35
http://www.morningstar.com/lp/magazine
Morningstar - Q2 2021

Table of Contents for the Digital Edition of Morningstar - Q2 2021
