Active bond managers believe that they can identify quality, low-risk bonds that will have large yields. In reality, bond managers are actually worse at beating the market than their equity counterparts. Only 15% of bond managers have been able to beat their benchmarks over the past 10 years. In comparison, an average of 19% of active equity managers beat their benchmarks.
Graphic 10: 15% of active bond fund managers beat their benchmark over ten years
Source: Dimensional Fund Advisors, using CRSP data provided by the Center for Research in Security Prices, University of Chicago. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein is compiled from sources believed to be reliable and current, but accuracy should be placed in the context of underlying assumptions.
EVEN FIXED INCOME INVOLVES RISKS
The idea that fixed income is riskless is a misconception. Daily shifting interest rates cause every bond to have volatility or risk. With bonds, there is an inverse relationship between interest rates and bond prices. When interest rates go up, bond prices go down. For example, if you were to purchase a $10,000, 20-year duration Treasury bond with a yield of 3%, and interest rates increased to 4% the following month, the bond would only sell for about $8,000. The opposite is also true: falling interest rates result in higher bond prices.
There are two primary forms of risks within bonds:
- Credit risk: the risk that a bond issuer will default. It is a low but present risk. Every bond has a rated level of risk (A, AA, etc.), but no rating system can predict every possible eventuality for every given issuer.
- Interest-rate risk: the risk that increasing interest rates will cause existing bonds to decrease in market value. The longer it takes for a bond to mature, the more likely that interest rate changes will affect its value.
STRETCHING FOR HIGH YIELD CAN BE AS RISKY AS THE STOCK MARKET
The temptation to achieve higher yields can be almost irresistible, even to the most seasoned investor. There are two ways to increase yields: extending maturities or lowering credit quality. However, both allow substantial risk to seep into your bond portfolio. Risk and return are related; by switching into riskier bonds, cracks can form in the sturdy foundation of a balanced portfolio and compromise returns.
Graphic 11: Fixed income has the potential for loss due to interest rate changes and defaults
Potential loss is the hypothetical effect of a 2.65% increase in interest rates (which represents the largest historical annual change in 7-year treasury bond rates since 1990, according to the U.S. Treasury) plus a default similar to that of 2008 (calculated by applying the average historical default rate for each S&P rating category to current fund holdings, according to StandardandPoors.com/ratingsdirect). Portfolio allocation is a split between iShares Short-term IPS (STIP) and Barclays High Yield (JNK) that results in integer for yield-to-maturity. Source: Data from Morningstar. Information contained herein is compiled from sources believed to be reliable and current, but accuracy should be placed in the context of underlying assumptions. Past performance is not a guarantee of future results.
Source: Data from Morningstar. Information contained herein is compiled from sources believed to be reliable and current, but accuracy should be placed in the context of underlying assumptions. Past performance is not a guarantee of future results.
CHASING HIGHER YIELDS MAY CAUSE DISPROPORTIONATELY HIGHER LOSSES
By calculating the downside loss that could result from investing in bonds with longer duration and lower credit quality to increase yields, we have identified the risks of reaching for a higher yield. As illustrated by Graphic 11, a high-yield bond investor aiming for a yield of 7% could lose 24% of his or her capital in a single year if interest rates rise and bond defaults occur at historical highs in the worst case scenario.
Investors do not often realize that risky, high-yield bond funds are similar to risky, high-yield equity funds, within that they both involve a possibility of substantial losses. Investors who need a higher return than short-term, high-quality bonds can create must accept some principal volatility. Having a diverse bond portfolio across several credit ratings, with shorter durations, limits interest rate risk and credit risk. Bond portfolios can be tilted either to principal preservation or income generation, but not to both.
Our team helps investors decide whether to add more exposure to equity markets or intermediate-term investment-quality bonds.