With little fanfare, many traditionally safe investment-grade bond funds have been edging into more complex corners of fixed income.
The goal: to eke out returns in today’s low-interest-rate world.
At issue is just how big some of those risks might turn out to be. Of particular concern is whether managers are moving into investments that could prove difficult to sell in the event investors rush for the exits. High-profile problems at several European funds have set nerves on edge and in the U.S. investors will probably need to be more vigilant.
“It can definitely be a disaster,’’ said Clark Randall, founder of financial planning and advisory firm Financial Enlightenment, if investors don’t keep tabs on whether their bond fund manager is moving further and further into junk-rated debt.
Spotting trouble isn’t easy. Part of the issue is that there are multiple types of risk including credit risk and illiquidity risk. With the first, managers may add less creditworthy investments to portfolios. The other comes if their holdings become difficult to offload. U.S. regulators define assets as illiquid if they cannot be sold within seven days at their approximate booked value.
For now, recent blowups involving illiquid investments have been contained to Europe. The SEC has been looking into the question of fund liquidity for several years and, for now, few money managers — on either side of the Atlantic — foresee an imminent crisis.
Yet a warning from the head of the Bank of England last week focused attention on potentially hard-to-trade investments. Small-time fund investors might be unaware of the risks, financial advisors warn.
The potential for trouble is clear. At Natixis-backed H20 Asset Management in London, concern over investments in unrated bonds helped spur billions of dollars’ worth of withdrawals in a matter of days.
“Liquidity risk has been socialized,” said Mike Terwilliger, a portfolio manager who runs the Resource Credit Income Fund, an interval fund that restricts quarterly withdrawals to 5% of total assets. “It sits on the portfolio of every single mom and pop investor, and they have no idea about that risk.”
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Illiquid investments aside, many relatively straightforward U.S. bond funds have increased their holdings of lower-rated bonds, emerging-markets debt and other securities to juice returns.
The trend led Morningstar to change how it classifies U.S. bond funds. In April, the data company broke out two different intermediate bond fund categories. One, called “intermediate core bond,” sticks to U.S.-dollar investment-grade debt, while limiting exposure to below-investment-grade assets. The other, “intermediate core-plus bond,” has more flexibility, typically holding larger positions in emerging-markets and non-U.S.-dollar debt as well as bank loans.
“At some point that category just got bigger and bigger,” said Eric Jacobson, a senior analyst at Morningstar. “When we analyze fixed-income funds, it’s fair to say our first area of focus is almost always risk.”
Funds that have taken a bit more risk have paid off for investors. Over the past five years, those in the riskier core plus category returned an average of 2.86%, while the core ones returned 2.53%, according to Morningstar data.
The shift toward riskier debt has been underway for years. In at least eight of the large bond funds Morningstar broke out as “core plus,” the allocation to government and AAA-rated debt decreased between 2006 and 2018. The allocation increased to BBB, the lowest investment grade rating available from Standard & Poor’s.
The JPMorgan Core Plus Bond Fund landed in Morningstar’s new category. At the end of November, the fund held asset-backed securities valued at $2.48 billion, or almost 18% of its $14 billion in net assets, according to a regulatory filing. That compared with $213.5 million of asset-backed securities, equaling about 7.2% of the fund’s $2.95 billion in net assets, at the end of February 2013.
In valuing these asset-backed bonds this February, the fund grouped 22% of the debt into an accounting category for those that are priced through the use of “significant unobservable inputs” because they trade infrequently. The comparable figure as of February 2013 was 32%.
“Generally, the asset-backed debt held by the JPMorgan fund is high quality, which makes it easy to sell, even if it trades infrequently,” said Darin Oduyoye, a spokesman for JPMorgan Asset Management.
Another “core plus’’ fund, the Dodge & Cox Income Fund, has increased the percentage of bonds in its portfolio that are rated one level above junk. Investments in government and AAA debt declined to 48% at the end of 2018 from 66% at the end of 2006.
Meanwhile, assets rated Baa, which are Moody’s Investors Service’s equivalent of BBB, rose to 32% at the end of last year from 13% at the end of 2006. Such debt comprised 13.6% for the Bloomberg Barclays U.S. Aggregate Index, a benchmark for many core bond funds, at the end of 2018.
The fund’s investments are diversified across issuers and industries and “were carefully vetted and selected through our time-tested credit research process,” said Thomas Dugan, co-director of fixed income at Dodge & Cox.
The SEC, which has been concerned about mutual fund liquidity since at least 2015, limits holdings of illiquid securities to 15%. Funds are required to provide a confidential breakdown on the liquidity of their holdings to the regulator, and, as of last month, must also include a discussion on how they manage liquidity risk in annual reports to investors.
But as Terwilliger points out: “When the market turns, those assets are going to be exceptionally challenging to trade relative to their bond equivalents,” he said. “What the illiquidity premium provides, the illiquidity premium will take away in the downturn.” — Additional reporting by Josh Friedman
