Yield is Underrated
Yield is often overlooked as an indicator of risk.
If you are looking to re-evaluate the risk in your portfolio, you might want to take a closer look at yield—specifically the yield for higher-risk asset classes like bank-loan funds (also known as senior-loan or floating-rate funds). It is common to look at these funds’ credit-quality ratings relative to one another and cash holdings to gauge the funds’ liquidity, or perhaps pore over analyst reports to assess the presence of other risk factors. But have you ever considered looking at yield? Often overlooked in favor of total return, yield might be a useful shortcut for evaluating the risk levels of these funds.
Investors may do themselves a disservice by gravitating to the highest-yielding products, but yield can still be a useful marker of risk—especially for bonds and bond funds. That is not to say that lower-yielding funds are automatically safer (that is not necessarily the case) or that higher-yielding ones should be marked with a skull and crossbones. But if you are looking for a shortcut to understand the risk profile of your fixed-income holdings, yield is not a bad starting place.
Deals Like This Will Not Last
The reason why yield can be such a useful indicator of risk in bonds and bond funds relates to arbitrage, the tendency for market participants to swoop in when unwarranted price discrepancies emerge. Everyone is on the hunt for return, so if there is a bond out there that has a higher yield than other investments with similar risk attributes, investors will tend to bid it up in a hurry, pushing down its yield. Yield inefficiencies, meaning you can earn an above-average yield without taking any additional risk, rarely persist for long among bonds, especially high-quality ones that are widely traded. For one thing, yield is the bulk of all of the return you earn as a bond investor; what you see is usually what you get, especially for high-quality bonds. Moreover, there are a lot of bonds with similar characteristics in terms of maturity, credit quality, and so forth, and many professional investors use computer programs to sort among them. If a bond has a compelling yield relative to other bonds with similar attributes, it will not tend to be able to maintain it for long.
That is why yield can be so useful as a risk marker, especially for bundles of bonds held in mutual funds. It may be possible or one or two bonds with higher yields to go unrecognized, even if they have no more risk than lower-yielding bonds with similar attributes. There can be structural reasons that contribute to pricing inefficiencies in a given market, too; for example, other market participants may not be able to invest in a given bond type, thinning the pool of investors who can invest in them and contributing to the possibility of pricing inefficiencies. The municipal-bond market is a good example. Because institutional investors like pensions do not benefit from the tax break that munis earn, the pool of muni buyers is constrained to start with. And there simply might not be that many market participants who are looking for North Carolina mid-quality bonds. Pricing inefficiencies can more readily emerge in less efficient markets than in hyper-efficient ones like Treasuries and high-quality corporates.
But think of it this way: If a bond fund amasses a whole portfolio of bonds that are yielding more than rival funds investing in the same pool, which can be a signal that its manager is systematically accepting higher risk in exchange for delivering a higher yield. That may give it a return edge—even a persistent one—but it is also likely to translate into higher volatility and the potential for real losses if you need to sell a bond or a bond fund amid a period of weak performance. A propensity to invest in lower-quality but higher-yielding credits may contribute to performance that moves as much in line with stocks than bonds; lower-quality, high-yielding bonds are not likely to be as effective on the diversification front as high-quality bonds.
Of course, it is also important to point out that funds can deliver higher yields than their peers in another way, and that is by keeping their expenses down. A fund’s expense ratio is deducted from its yield, so a fund charging 0.50% per year will have a better yield than one with an identically invested portfolio and a 0.75% expense ratio. That is why a key check before assuming that a fund is taking on big risks relative to its peers is to assess its expense ratio. If a bond fund’s fees is higher than its peers that should be your cue to sniff around for what risks it is taking to deliver it. Managers may take additional risks to help overcome the yield reduction that accompanies a high expense ratio.
Most Useful for Less Obvious Risks
Those risks can come in a few different forms. The obvious two risk levers that funds can pull to deliver a higher yield than peers are interest-rate risk and credit risk. Credit risk is more common among core bond funds; to help you identify how much credit risk lurks in a portfolio.
Those risks are fairly simple to sleuth out at the portfolio level, but there are other instances when yield can be particularly useful as a risk flag. One is if the bonds in a portfolio are not rated, or if the data on portfolio holdings are not widely available. Yield can also be a useful risk marker if a fund traffics in illiquid bonds; if other bond-market participants believe they may not be able to unload the bond in bad market conditions, the bond’s yield will be higher than the yields on other bonds.
You may decide that you are OK with the volatility that can accompany higher-yielding bonds and bond funds. But if you own bonds to serve as the shock absorbers for the truly risky investments in your portfolio, the highest yields will not be your best options.
© Morningstar 2019. All Rights Reserved. Used with permission.
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