Even though positive recent economic data has laid to rest fears about a potential double dip, investors don't seem to be celebrating. Skepticism and fear are still the order of the day as folks continue to yank money out of stocks and stuff it into the perceived safety of bonds. According to Investment Company Institute data, for the week ending Sept. 15, investors withdrew another $3.6 billion from domestic stock funds, and added $7.4 billion to taxable bond funds.
As this years-long trend shows few signs of subsiding, some gurus have warned of increased risk in the bond market, which has receieved massive amounts of cash in recent years. Now, one big change in how Morningstar calculates credit risk for all bond funds may make some of those risks a bit more apparent to investors.
Revamping risk
Earlier this month, Morningstar released its new average credit quality ratings for the universe of fixed-income funds the firm covers. Morningstar adjusted its methodology so that lower-rated bonds, and higher predicted default rates for these bonds, were counted more heavily in the calculation.
As a result, more than half of all domestic taxable bond funds tracked by Morningstar have seen their average credit quality fall, sometimes by a lot. According to the Wall Street Journal, the TCW Short-Term Bond Fund (TGSMX) saw its average credit quality fall from AA to a below-investment-grade BB rating, while the Federated Real Return Bond Fund (RRFAX) fell from a top-rated AAA to BBB. These new ratings could have further implications for individual investors and many investing committees, who may be required to invest in funds that have a certain minimum credit quality.
If you own a bond fund that has suddenly seen its average credit quality drop under Morningstar's revamped ratings, don't panic. Keep in mind that your fund hasn't suddenly changed overnight; it likely owns the exact same securities that it did a few weeks ago, and it hasn't suddenly amped up its risk in lower-quality bonds. As the folks at Morningstar have indicated, you probably shouldn't worry if your fund has fallen a notch on the credit quality scale as a result of the change in methodology.
Still on top
But what if your fund has dropped by a more than a notch, as some of the funds noted above have? In such a case, you may want to at least take a closer look at your fund's underlying holdings. Exactly how much of the portfolio is allocated to below-investment-grade (below BBB) securities? Although default rates have likely peaked in the current credit cycle, a fund with significant lower-quality holdings could face higher risks than you may realize or want.
Fortunately, there are still a wide number of broad-based bond funds that still measure up, even with the revised credit quality rankings. PIMCO Total Return (PTTAX), the largest mutual fund in existence, has been run by bond maven Bill Gross since its 1987 inception. Even with roughly 7% of the portfolio in foreign bonds and another 17% in corporate bonds, the fund retains an overall A credit quality rating. In fact, 64% of its holdings are AAA-rated, according to Morningstar data.
For exchange-traded fund fans, the Vanguard Total Bond Market ETF
Chasing returns
Lastly, while Morningstar's revamped credit quality ratings may give investors a better idea of the potential credit risks involved in the funds they buy, it doesn't change the general interest rate risks that the entire industry is facing down the road. Since rates have practically nowhere to go but up, that means bonds and bond funds are likely to face declining prices in the years ahead, disappointing the rush of investors who are hoarding their money in bonds.
While long-term investors should always have at least some fixed-income exposure, and retirees are likely to need at least of their portfolio in bonds, investors who are fleeing the stock market out of fear may want to reconsider. Bonds aren't likely to outperform stocks in the coming years as they did in the past. If you don't need your money for at least another five to 10 years, you might want to consider some solid dividend-paying stocks as an alternative to some of your fixed-income exposure.
For example, T. Rowe Price Equity-Income (PRFDX) manager Brian Rodgers looks for established firms with decent dividend yields that have been beaten up a bit in the short-term. Some of his favorite stocks include energy giants Chevron
Bonds will always be a necessary part of every investor's portfolio, but people should remember that bonds and the funds that invest in them are not risk-free. Morningstar's new credit ratings may give investors better insight into some of those risks, but there are no guarantees for the tens of billions of dollars currently being shoveled into the fixed income sector, so invest here with caution and a continued long-term outlook.
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