What’s really inside bond funds these days?
The answer, for many of them, is more risk than there used to be.
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 U.S. Securities and Exchange Commission 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 advisers warn.
The potential for trouble is clear. At Natixis SA-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.”
Illiquid investments aside, many relatively straightforward U.S. bond funds have increased their holdings of lower-rated bonds, emerging-market debt and other securities to juice returns.
The trend led Morningstar Inc. 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.