The Risks and Rewards of Diversifying Your Bond Funds
With interest rates so low, some advisers think investors have too much to lose by focusing solely on bond index funds
With interest rates so low, some advisers think investors have too much to lose by focusing solely on bond index funds
Baby boomers investing for retirement back in the ’80s, ’90s and ’00s rarely had to worry about the bonds in their nest eggs.
Bonds back then mainly served as risk-reducing ballast for when stocks tanked. And they weren’t that much of a sacrifice because they often paid healthy interest yields of 5% or more.
But now, when boomers are supposed to have increased bond weightings in their portfolios—40% or more of a nest egg, according to the conventional wisdom—rates have fallen to the floor. Interest yields on a bond index fund are as low as 1.1%. As a result, retirees and other index bond investors are left staring at tiny interest coupons and a greater risk of rising rates, and thus of lost principal.
“With interest rates near their historic lows, so close to zero, there’s generally only one direction they can go,” says Steve Kane, a manager of the $90 billion MetWest Total Return Bond fund (MWTRX).
In response, investors might want to consider adding to their fixed-income portfolios some bond funds that can offer higher yields than U.S. bond index funds and offer varying degrees of protection from the risk of rising rates. At the moment, commonly used bond-market calculations suggest that for every percentage-point rise in rates, a U.S. bond index fund will lose about 6% in price, wiping out years of interest receipts.
The main reason bond index funds are likely to get hit so hard is because of a feature in the index funds’ most widely used benchmark, the Bloomberg Barclays U.S. Aggregate. The “Agg,” as it’s known, is heavily weighted to the most conservative U.S. government bonds.
This investment-grade-only index is thus more vulnerable to rising rates because it doesn’t include some riskier categories of bonds such as high-yield, or “junk,” bonds, or floating-rate loans that pay higher interest and are often found in actively managed bond funds.
Indeed, sponsors of some actively managed target-date mutual funds—multiasset funds whose mix of investments grows more conservative as investors age—take action to serve retirees’ need for extra income by adding “diversifying buckets” of funds that aren’t part of the Agg index.
T. Rowe Price Group Inc., for example, puts about one-sixth of the bonds in its target-date fund for 70-year-olds in high-yield (or junk-bond), emerging markets and floating-rate funds. JPMorgan Chase & Co. puts one-fifth of retirees’ bonds in high-yield and emerging markets.
A series of retiree investment models designed by Morningstar personal-finance director Christine Benz allocates 14% to 22% of bonds to such categories, depending on investors’ risk appetites. Such bonds can “bump up yields and provide extra diversity,” Ms. Benz says.
The interest rates on these three kinds of funds may be double or triple that of a bond index fund. And funds that focus on some bonds, like high-yield and emerging markets, often outperform the index over a full market cycle. Funds of both types beat the index in the past decade, according to Morningstar.
These types of investments do make retirees’ portfolios riskier, however. All three categories got hit twice as hard as the safer index early last year, falling more than 20% in price while bond index funds fell just 8.6%, Morningstar says. Stocks fell 35% during the same period. Most of the losses have since been regained.
Still, seeking to avoid such swings is why some target-date fund sponsors, especially index managers like Vanguard Group, tend to avoid emerging-markets, junk and floating-rate bond funds.
Maria Bruno, head of U.S. wealth-planning research at Vanguard, says trying to boost bonds’ return this way is misguided. Ms. Bruno agrees with those who say bonds should be “ballast” for times when stocks tank. “They shouldn’t be seen as a return-generating investment,” she says.
Dan Oldroyd, head of target-date strategies at J.P. Morgan Asset Management, disagrees. Mr. Oldroyd says that with stock valuations “stretched,” adding risk in a bond bucket with high-yield and emerging markets is a reasonable step. Similarly, Kim DeDominicis, a target-date portfolio manager for T. Rowe, says high-yield and emerging-markets funds can offer possible higher returns and guard against rising rates with “modest increases to expected volatility.”
The target-date funds discussed earlier, including similar Vanguard funds, and the Morningstar buckets all include inflation-protected-bond allocations of 7% to 15% of total assets. While those bonds have yields near zero, they can help protect purchasing power if inflation kicks up.
Riskier, higher-yielding assets are common in actively managed bond funds. A majority of the dozen largest report holding more than 5% of assets in high-yield bonds; five say they have more than 5% in emerging-markets debt.
The $70 billion Bond Fund of America has 6.9% in high-yield and emerging markets. Margaret Steinbach, a fixed-income director for the fund, says higher doses of these kinds of riskier allocations “could potentially compromise the downside protection” of bonds.
But others are more gung-ho. “We’ve been adding high-yield and emerging-markets bonds,” says Mike Collins, co-manager of the $64 billion PGIM Total Return Bond Fund, which holds 14.8% in the two categories. He says individuals could hold as much as half of their bonds in such riskier buckets, depending on their time horizon and risk tolerance.
For do-it-yourself index investors who want to add such exposure, Ms. Benz suggests Vanguard High-Yield Corporate fund (VWEHX), iShares J.P. Morgan USD Emerging Markets Bond (EMB) exchange-traded fund and Fidelity Floating Rate High Income fund (FFRHX).
Less-daring options include bumping up the yield only slightly with an investment-grade corporate bond fund, or moving some bond assets to lower-yielding money-market funds or short-term bonds to reduce interest-rate risk.
Morningstar bond-fund analyst Eric Jacobson says retired bond investors can also try to boost returns more safely by choosing an active manager from among top core-plus bond funds—which typically allocate 15% to 20% of their assets to riskier debt—such as Mr. Kane’s MetWest Total Return Bond fund, Dodge & Cox Income (DODIX) or Fidelity Total Bond ETF (FBND).
While that requires paying a much higher fee on one’s entire bond bucket than for a bond index fund, Mr. Jacobson notes that active bond managers have generally outperformed the index, thanks partly to the riskier assets.
Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual
Government spending, including Biden’s Inflation Reduction Act, has helped drive a gap between clean-energy spending and fossil-fuel investments
Investments in solar power are on course to overtake spending on oil production for the first time, the foremost example of a widening gap between renewable-energy funding and stagnating fossil-fuel industries, according to the head of the International Energy Agency.
More than $1 billion a day is expected to be invested in solar power this year, which is higher than total spending expected for new upstream oil projects, the IEA said in its annual World Energy Investment report.
Spending on so-called clean-energy projects—which includes renewable energy, electric vehicles, low-carbon hydrogen and battery storage, among other things—is rising at a “striking” rate and vastly outpacing spending on traditional fossil fuels, Fatih Birol, the IEA’s executive director said in an interview. The figures should raise hopes that worldwide efforts to keep global warming within manageable levels are heading in the right direction, he said.
Birol pointed to a “powerful alignment of major factors,” driving clean-energy spending higher, while spending on oil and other fossil fuels remains subdued. This includes mushrooming government spending aimed at driving adherence to global climate targets such as President Biden’s Inflation Reduction Act.
“A new clean global energy economy is emerging,” Birol told The Wall Street Journal. “There has been a substantial increase in a short period of time—I would consider this to be a dramatic shift.”
A total of $2.8 trillion will be invested in global energy supplies this year, of which $1.7 trillion, or more than 60% will go toward clean-energy projects. The figure marks a sharp increase from previous years and highlights the growing divergence between clean-energy spending and traditional fossil-fuel industries such as oil, gas and coal. For every $1 spent on fossil-fuel energy this year, $1.70 will be invested into clean-energy technologies compared with five years ago when the spending between the two was broadly equal, the IEA said.
While investments in clean energy have been strong, they haven’t been evenly split. Ninety percent of the growth in clean-energy spending occurs in the developed world and China, the IEA said. Developing nations have been slower to embrace renewable-energy sources, put off by the high upfront price tag of emerging technologies and a shortage of affordable financing. They are often financially unable to dole out large sums on subsidies and state backing, as the U.S., European Union and China have done.
The Covid-19 pandemic appears to have marked a turning point for global energy spending, the IEA’s data shows. The powerful economic rebound that followed the end of lockdown measures across most of the globe helped prompt the divergence between spending on clean energy and fossil fuels.
The energy crisis that followed Russia’s invasion of Ukraine last year has further driven the trend. Soaring oil and gas prices after the war began made emerging green-energy technologies comparatively more affordable. While clean-energy technologies have recently been hit by some inflation, their costs remain sharply below their historic levels. The war also heightened attention on energy security, with many Western nations, particularly in Europe, seeking to remove Russian fossil fuels from their economies altogether, often replacing them with renewables.
While clean-energy spending has boomed, spending on fossil fuels has been tepid. Despite earning record profits from soaring oil and gas prices, energy companies have shown a reluctance to invest in new fossil-fuel projects when demand for them appears to be approaching its zenith.
Energy forecasters are split on when demand for fossil fuels will peak, but most have set out a timeline within the first half of the century. The IEA has said peak fossil-fuel demand could come as soon as this decade. The Organization of the Petroleum Exporting Countries, a cartel of the world’s largest oil-producing nations, has said demand for crude oil could peak in developed nations in the mid-2020s, but that demand in the developing world will continue to grow until at least 2045.
Investments in clean energy and fossil fuels were largely neck-and-neck in the years leading up to the pandemic, but have diverged sharply since. While spending on fossil fuels has edged higher over the last three years, it remains lower than pre pandemic levels, the IEA said.
Only large state-owned national oil companies in the Middle East are expected to spend more on oil production this year than in 2022. Almost half of the extra spending will be absorbed by cost inflation, the IEA said. Last year marked the first one where oil-and-gas companies spent more on debt repayments, dividends and share buybacks than they did on capital expenditure.
The lack of spending on fossil fuels raises a question mark around rising prices. Oil markets are already tight and are expected to tighten further as demand grows following the pandemic, with seemingly few sources of new supply to compensate. Higher oil prices could further encourage the shift toward clean-energy sources.
“If there is not enough investment globally to reduce the oil demand growth and there is no investment at the same time [in] upstream oil we may see further volatility in global oil prices,” Birol said.
Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual