April Multisector Bond Funds: An Alternative To Traditional Bonds?

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1 Multisector Bond Funds: An Alternative To

2 Multisector Bond Funds: An Alternative To As the economy continues to rebound from the Great Recession, interest rate increases become more and more likely. Because rising rates cause bond values to decline, investors may be tempted to look for an alternative to traditional bonds in their portfolios. One such alternative, multisector bond funds, has emerged as a popular option. Investors are drawn to them because they have provided more total return than the more traditional intermediate-term bond funds. However, a closer look raises questions about their suitability as a substitute for traditional bonds. An Overview Bonds can be an integral part of a diversified portfolio. They are typically used in a portfolio to provide income and to reduce the volatility of the portfolio over time. Bonds present two types of risks: Julie Grandstaff, CFA julie.grandstaff@standard.com stancorpadvisers.com About Julie Grandstaff Julie is responsible for the operational and investment activities of the firm. She founded the private client business within the institutional structure of StanCorp Financial Group. Julie holds an MBA from California State University, a bachelor of science degree in finance from Arizona State University and is a Chartered Financial Analyst. Interest-rate risk is the possibility that interest rates in the future for similar bond issues will be different than the interest rates offered on a given bond today. If future interest rates are higher, the bond will temporarily have less value until it approaches maturity. Conversely, if future interest rates are lower, the bond will be worth more. Credit risk hinges on whether or not the issuer will pay on their contractual obligations. Unlike temporary losses associated with interest-rate risk, credit-related losses are permanent. Not all bonds are alike and there is a wide variety to choose from. Government bonds, for example, have no credit risk, since the government guarantees payment; however, they do have interest-rate risk. Corporate bonds have both types of risk. High-yield corporate bonds have much more credit risk, as their issuers have a higher probability of default than do issuers with an investment-grade rating. The chart below shows different bonds exposure to the combination of interest rate and credit risk. Interest Rate Risk Long Maturity Intermediate Maturity Short Maturity Government Bonds Investment-Grade Corporate Bonds High-Yield Corporate Bonds Credit Risk Some bonds are backed by pools of loans such as residential or commercial mortgages, or credit card or auto loans. You may have heard these bonds referred to as mortgagebacked securities or asset-backed securities. These may be more sensitive to interest rates than typical government or corporate bonds because the underlying borrowers have rights to pay off their loans early. They can also expose your portfolio to a range of credit risks, depending on the structure of the pool of loans backing the bonds.

3 Multisector bond funds have one distinguishing feature: their significant allocation to high-yield bonds. In fact, Morningstar s definition for the category indicates that funds typically hold percent in high-yield bonds. Multisector Bond Funds Vs. Traditional Bond Funds Multisector bond funds invest across the universe of bond types, as do intermediateterm bond funds. However, multisector bond funds have one distinguishing feature: their significant allocation to high-yield bonds. In fact, Morningstar s definition for the category indicates that funds typically hold percent in high-yield bonds. Intermediate-term bond funds hold primarily investment-grade bonds. In the following section, we present several charts that indicate: Multisector bond funds typically hold a much higher allocation of high-yield bonds. High-yield bonds behave more like equities than bonds. Similarly, the average multisector bond fund performs more like equities than bonds. The following table shows the high-yield bond allocation for typical intermediate-term bond funds compared to multisector bond funds. Allocation To High-Yield Bonds Intermediate-Term Bond Funds Multisector Bond Funds Highest 25% 16.1% 58.7% Median 6.9% 49.3% Lowest 25% 1.5% 37.1% Source: Morningstar Direct, oldest share class as of February 28, 2014 The primary driver of risk in high-yield bonds is credit, and that makes them behave in the markets more like equities than bonds. The following table is a correlation matrix that compares the performance of investment-grade bonds, high-yield bonds and the S&P 500. Correlation is a statistical measure of how two securities perform in relation to each other. U.S. Investment- Grade U.S.Investment- Grade 1.00 U.S. High-Yield U.S. High-Yield S&P 500 S&P Sources: Barclays US Corporate Investment-Grade Total Return Index March February 2014 Barclays US Corporate High-Yield Total Return Index March February 2014 A perfect positive correlation would be shown as 1.00 and suggest that as one security moves either up or down, the other security will perform exactly the same. If the correlation is 0, the movements of the securities would have no correlation. The higher the number, the more the categories behave like one another. As you can see, highyield bonds correlate to the S&P 500 index by a factor of 0.72, which is higher than the correlation to investment-grade bonds of This indicates that high-yield bonds behave more like equities than bonds. Similarly, the average multisector bond fund has a high correlation to the S&P 500, which reflects the influence that high-yield bonds have on multisector bond performance. As you can see in the chart below, the correlation to the S&P 500 for funds investing in investment-grade bonds is much lower.

4 U.S. Investment- Grade U.S. Investment-Grade Multisector High-Yield S&P Multisector High-Yield S&P Sources: Morningstar US OE Intermediate Bond Category Average March February 2014, Morningstar US OE Multisector Bond Category Average March February 2014, Morningstar US OE High-yield Bond Category Average March February 2014 Multisector Bonds In Portfolios Historically, multisector bond funds have had higher overall returns than intermediateterm bond funds. The following table provides the historical returns of the two Morningstar category averages. Intermediate- Term Annualized Total Return Years 5 Years 10 Years 15 Years -1.42% 3.64% 6.31% 4.33% 4.95% Multisector 1.87% 5.71% 11.55% 6.06% 6.31% Sources: Morningstar US OE Intermediate Bond Category Average as of 12/31/2013, Morningstar US OE Multisector Bond Category Average as of 12/31/2013 Multisector funds don t add much diversification value to your portfolio if it already has a significant allocation to equities; intermediateterm bonds provide better diversification. However, given the high correlation to equities, multisector funds don t add much diversification value to your portfolio if it already has a significant allocation to equities; intermediate-term bonds provide better diversification. One research tool we use to evaluate portfolio allocations uses multiple allocation iterations to find the portfolio that historically would have had the highest return for a given level of standard deviation (a measure of risk) for a given set of investments. This tool found that multisector bond funds do not provide an improved trade-off between return and risk once the equity allocation reaches 30 percent. The following table shows the return for risk trade-off for a simple portfolio with two typical equity allocations, 40 percent and 60 percent. Using a simple portfolio of U.S. large cap equities and bonds, we can demonstrate that using intermediate-term bond funds instead of multisector bond funds would improve the return-to-risk ratio of a portfolio, based on historical data. 40% Equities 60% Equities Sub 20% MSB Allocation MSB Int Bd MSB Int Bd Large Cap Blend 40% 40% 60% 60% 40% Intermediate-Term Bond 0% 60% 0% 40% 40% Multisector Bond 60% 0% 40% 0% 20% Average 12 Month Return 7.46% 6.84% 8.01% 7.60% 7.05% Std Dev 12 Month Return 10.31% 8.40% 12.60% 11.32% 8.99% Return/Std Deviation *Average 12 month returns from 1993 to 2013 Looking at these numbers you can see that a portfolio of 40 percent equities has a return-to-risk ratio of 0.81 using intermediate-term bond funds, versus 0.72 with multisector bond funds. When the portfolio has 60 percent equities, the return-to-risk ratio is lower 0.67 with intermediate-term bond funds versus 0.64 with multisector bond funds. But if we take that traditional portfolio with 60 percent equities and substitute 20 percent of the equity allocation with multisector bond funds, we see a better improvement in the return-to-standard deviation ratio 0.78 versus 0.67 for the 60 percent equity ratio.

5 When multisector bonds are substituted for 20% of the equity allocation, only 0.55 percent of return is given up, but the risk, represented by standard deviation, is reduced by 2.33 percent. These results indicate that multisector bond funds are actually a better substitute for equities in a portfolio than they are for bonds. Our Approach At StanCorp Investment Advisers, we generally populate the bond portion of investment portfolios with intermediate-term bond funds. These bond funds invest across a range of bond types, but generally the investments are of high quality. High-yield bonds present too much risk for use in the bond portion of the portfolio, as do multisector bond funds. 1 We understand why you might be tempted to add multisector bonds as a substitute for all or part of the bond portion of your portfolio, especially when you see better returns provided by the average multisector bond fund compared to the average intermediateterm bond fund. But multisector bond funds deliver equity-like risk and therefore don t belong in the bond allocation. If you re interested in using multisector bond funds, they should be part of the equity allocation, where historically they have reduced risk more than they have reduced return. 1 It is possible that some bond funds we use may have a small allocation to high-yield bonds.

6 About StanCorp Investment Advisers Helping you achieve lifelong financial well-being is the primary focus of StanCorp Investment Advisers, Inc. We have a fiduciary duty to act in your best interest and adhere to a prudent, unbiased approach to managing your money. Our asset management process starts with learning about you and your goals. Your advisor will recommend a portfolio structure that invests your assets according to your specific time frame. We go beyond your portfolio to take a comprehensive look at all aspects of your financial life and provide guidance to set you on a path to financial well-being StanCorp Investment Advisers, Inc. All rights reserved.