Since the 2008 financial crisis, the intermediate-term bond category has grown from less than $500 billion in assets to nearly $930 billion, says Eric Jacobson, Morningstar’s director of fixed-income research. At the same time, fund managers have also shifted how they manage core portfolios.
While most intermediate-term bond funds use the Barclays Capital U.S. Aggregate Bond Index as their benchmark, fewer than 12% of funds in the category managed to match or beat the return of the Barclays Aggregate Index in 2011, he notes. At the same time, many core bond funds have added holdings in commercial mortgages and high-yield corporate bonds.
Morningstar analysts recently looked at the funds’ R-squared statistics to measure how much of a particular fund’s returns over a given period (36 months) could be explained by the returns of the index; the higher the R-squared number, the tighter the correlation.
“What it shows is fairly dramatic: R-squared figures for the average fund in the group began dropping in 2008, much as one would have expected given the opportunistic buying that occurred as the market swooned. But while the figure leveled out in the low 70s starting in early 2009, it never returned to the formerly high–that is, very close to 100–levels that it occupied in years prior to the crisis,” writes Jacobson.
Plus, the statistic began to fall even further beginning last summer. On a trailing three-year basis ended February 2012, the average fund in the intermediate-term bond category now carries an R-squared of roughly 62, the Morningstar analyst notes.
Vanguard’s intermediate-term investment-grade fund, for instance, which historically fashioned itself a mostly corporate-bond portfolio, has recently held 7% in asset-backed securities and 4.4% in commercial mortgages; its R-squared in relation to the Barclays Aggregate has dropped to 54 from 98 prior to the financial crisis, shares Jacobson.
With so many funds branching out of their former “comfort zones” and investing in areas that once occupied little or no space in their core portfolios, “the risk that investors will get something other than they bargained for has inevitably gone up,” the analyst concludes.