Download Beyond Duration: Comparing Taxable Bond Funds

Beyond Duration: Comparing
Taxable Bond Funds
Market Commentary
August 2016
INTEREST RATE SENSITIVITY IS AN IMPORTANT FEATURE OF ANY BOND FUND, but there are
many factors to consider beyond duration. Equity analytical tools proliferate,
yet fixed income investors tend to rely on only a few simple metrics.
Deciphering fixed income products is further complicated by substantial
variation in fund composition, even within a peer group. As the population
ages and fixed income needs increase, understanding what’s in a bond fund
becomes more important to building effective portfolios. Consider these hints
to help unravel the often confusing world of bond funds.
Start with the Category
Morningstar and Lipper offer several fixed income categories that span the bond fund
universe. We will concentrate our discussion on those categories commonly used in fixed
income portfolio allocations
The Lipper categorization generally provides more fixed income categories with finer
distinctions than Morningstar. For example, the Short-Intermediate category contains
funds with slightly shorter duration than the Intermediate-Term category. Lipper’s
recent delineation of the Core and Core Plus categories divides that very large universe
into conservative and aggressive segments. Overall, the largest categories include:
▪▪ Morningstar Intermediate-Term Bond – Invests primarily in corporate and other
investment-grade U.S. fixed income issues with durations of 3.5 to 6.0 years.
▪▪ Lipper Core Bond – Invests at least 85% in domestic investment grade debt issues.
Funds are likely to be benchmarked to the Barclays U.S. Aggregate Bond Index.
▪▪ Lipper Core Plus Bond – Includes greater allocation to higher risk/reward sectors
outside of the Aggregate Index, including high yield (or below investment grade)
bonds, non-U.S. dollar denominated bonds and emerging market debt. Specifies
at least 65% in domestic investment grade debt issues. Those seeking more return
potential may consider this more aggressive category.
▪▪ Morningstar Multi-Sector Bond/Lipper Multi-Sector Income – Offers a much
higher allocation to below investment grade debt and foreign debt. These categories
have become increasingly popular for investors seeking more return potential and
less interest rate sensitivity. Morningstar describes the portfolios as typically holding
35 to 65% in below investment grade while Lipper states only a “significant portion”
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
Paul Blomgren
Senior Vice President,
Client Portfolio Manager
Nuveen Asset Management, LLC
Beyond Duration: Comparing Taxable Bond Funds
August 2016
of assets. These categories contain some of the very popular
strategic income funds.
Do any sectors have more detailed segmentation? This
often indicates a bias. If the fund has a larger allocation to a
sector, it may display more details. For example, a fund offering
more detail in the corporate sectors may have a larger stake in
corporates overall, and over time, indicating its bias.
▪▪ Morningstar Nontraditional Bond – Employs absolute
return strategies that are sometimes described as
“unconstrained” and typically use a cash benchmark. We have
seen a significant increase in this type of fund. Morningstar
describes these funds as “pursuing strategies divergent in one
or more ways from conventional practice in the broader bond
fund universe.” Morningstar classifies these funds together,
while Lipper offers three distinct categories.
What is the benchmark? Many intermediate-term funds
use the Barclays U.S. Aggregate Index as their benchmark;
sometimes the Barclays Intermediate Government/Credit
Index is used. This may mean the fund has a lower allocation
to mortgage-backed securities (MBS) because the Barclays
Intermediate Government/Credit Index does not include
the MBS sector.
Exhibit 1: Selected Bond Categories
Morningstar
Category
Lipper Category
Typical Benchmark
Intermediate
Term Bond
Short-Intermediate
Investment-Grade Debt
Barclays Intermediate
Aggregate Bond
Core Bond
Barclays U.S. Aggregate Bond
Core Plus Bond
Barclays U.S. Aggregate Bond
Multi-Sector Income
Barclays U.S. Aggregate Bond
Multi-Sector
Bond
Nontraditional Absolute Return
Bond
Alternative Credit Focus
Cash
Specialty Fixed Income
Cash
Exhibit 2 shows sample sector allocations from different fact
sheets. All four funds fall in the Morningstar Intermediate-Term
Bond Category.
Exhibit 2: Funds in the Same Category Differ Greatly
Fund #1
Sector Distribution
Cash
Read the Factsheet
The fund factsheet provides more specific information. It
outlines the composition of the fund, which is important
to understanding what will likely drive fund performance.
The benchmark and peer group will often be shown in the
performance comparison, which can also be very insightful. And
sometimes key prospectus limits will be disclosed.
Fund
Index
Inv. Grade Credit
34.0%
43.8%
Non-U.S. Dollar (ex CAD)
18.4%
—
Canadian Dollar
15.9%
—
High Yield Credit
14.6%
—
Convertibles
6.5%
—
U.S. Treasury
4.3%
52.1%
ABS/RMBS
1.6%
—
CMBS
1.5%
—
Municipal
0.8%
0.4%
Preferred/Equity
0.8%
—
Bank Loans
0.4%
—
Examine the Sector Composition
U.S. Agency
—
3.6%
The sector allocation shows how much the fund owns of each
type of bond. Look for a few things:
Cash & Equivalents
1.1%
—
▪▪ The benchmark contains only government and corporate
How do the fund’s positions deviate from the index?
Funds that have allocations closer to the benchmark may be
more conservative than those with large deviations. Since many
intermediate-term bond funds use the Barclays U.S. Aggregate
Bond Index as their benchmark, it is helpful to know something
about that index’s composition.1
bonds, so it is not the Barclays U.S. Aggregate Bond Index,
which contains MBS.
▪▪ Since the benchmark contains no MBS, the portfolio is
unlikely to contain large amounts of MBS.
▪▪ 15% in high yield signals a moderately aggressive portfolio.
▪▪ The detailed breakout of the Canadian Dollar may indicate a
large and persistent presence of this type of holding.
1Source: Barclays. The Barclays U.S. Aggregate Bond Index was 37% Treasuries, 2% Agencies,
28% Mortgage-backed securities, 31% Corporates, 2% CMBS and 0.5% ABS as of 6/30/16.
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Beyond Duration: Comparing Taxable Bond Funds
August 2016
Fund #2
Fund #4
Sector Diversification
Sector Allocation Breakdown
Government – Treasury
83.6%
Government – Agency
0.0%
Energy
29.8%
Cash
24.8%
Swaps and Liquid Rates
-43.9%
Asset Backed Securities
15.5%
Mortgage
47.6%
Financial
13.7%
Invest. Grade Credit
15.0%
Treasuries
6.4%
High Yield Credit
3.5%
Basic Materials
3.9%
Non-U.S. Developed
-0.2%
Diversified
2.6%
Emerging Markets
8.7%
Consumer Cyclical
1.6%
Bonds and Other Long Duration Instruments
7.5%
Communications
1.3%
Short Duration Instruments
1.3%
Consumer Non-Cyclical
0.5%
Municipal
4.0%
Other
Net Other Short Duration Instruments
1.6%
-20.0%
▪▪ Corporate bond market is segmented (not labeled investment
grade corporate). This reveals it is a corporate bond fund, not a
more diversified product.
▪▪ Large allocations to Treasury and mortgage sectors signal a
Understand the Limits
different strategy in this fund.
▪▪ Negative allocation to swaps and liquid rates and net other
short duration instruments signal heavy use of derivatives.
▪▪ Detail on emerging market exposure segments large position
in more volatile sector.
Key prospectus limits will sometimes be listed on the factsheet
or in the summary prospectus under Investment Guidelines.
The allocation limit to below investment grade debt can vary
substantially. A fund may have no ability to invest in below
investment grade debt, or it can have larger allocations.
Fund #3
Typically, core funds do not allow much if any below investment
grade debt. Core plus funds might allow 15% to 35%. Larger
allocations are for more aggressive funds, often in the multisector bond categories. Prospectus limits are difficult to change,
so they are written very broadly. Compare the limit to the
fund’s current positioning. Usage can vary depending on current
markets, so knowing if a sector is considered attractive can put
the current positioning into perspective.
Sector Breakdown
Cash
12.1%
Treasury
3.4%
Agency Pass-Throughs
28.1%
Agency CMO
21.1%
Non-Agency Residential MBS
20.6%
Commercial MBS
7.3%
Collateralized Loan Obligations
4.5%
Other
2.7%
Total
100.0%
Consider the Yield
The 30-day SEC yield attempts to measure the portfolio’s
current income generation. It is standardized and considers sales
charges. Look at a no-load share class (Class I or Y) to better
understand yield. The 12-month yield is calculated by dividing
the past 12-month’s dividends by the current price. It gives a
better idea of the fund’s yield over time.
▪▪ MBS sector is segmented (agency-pass through, agency
CMO, non-agency residential MBS and commercial
MBS) and a hefty 77% allocation makes this more of a
mortgage sector fund.
A higher yield versus the peer group means the fund is doing
something more aggressive like adding high yield corporate
bonds, emerging market debt or other higher-yielding
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Beyond Duration: Comparing Taxable Bond Funds
August 2016
asset classes. A large difference between the SEC yield and
the distribution yield can also signal something about a
fund’s strategy.
Exhibit 3: The Tale of Three Strategic Income Funds
Fund #1
Benchmark = Barclays U.S. Universal, BofA ML 3-Month U.S. Treasury Bill Index
Effective Duration = 1.77 years
Review the Duration
Sector Allocation
Duration doesn’t vary much in traditional intermediate-term
bond funds. It is typically 4 to 6 years, similar to the Barclays
U.S. Aggregate Bond Index. But it can vary over time. Duration
substantially longer or shorter than the benchmark signals that
the fund may take more interest rate risk than the average peer.
This can create more performance volatility over time.
High Yield
Cash
Non-Agency MBS
Credit Relative Value (RV)
Bank Loans
Commercial Real Estate
Other
CMBS/ABS
Agency MBS
EMD/Sovereign
Investment Grade Corporate
Duration measures interest rate sensitivity. For every year of
duration, a parallel shift of the yield curve upward 1% will
result in a 1% decline in price, all other things equal. The last
part is most important. While duration indicates how much
prices may move, it is not precise. The types of bonds, changes
in yield spread, curve reshaping and other factors will impact
each bond in the portfolio differently. Duration is an estimate,
not an absolute.
44.2%
18.2%
9.1%
8.9%
6.1%
5.3%
3.5%
1.8%
1.7%
0.9%
0.2%
▪▪ Cash benchmark and shorter duration signal more absolute
return approach.
▪▪ High cash allocation at 18% may be a hedge against market
risk or collateral for derivative positions.
▪▪ Probably not suitable for a large portion of fixed
income allocation.
What About the Fund’s Name?
A fund’s name can either be helpful or confusing in
understanding the fund’s objectives. The SEC “Name Rule”
requires a fund with a term in its name to hold at least 80% of
that type of investment. For example, a fund with “investment
grade” in the name will have a large allocation to investment
grade bonds. What about that other 20%? The composition
of that smaller portion of the portfolio can often drive return
differences. For example, in Exhibit 2, Fund #1 uses “investment
grade” in the name, but allocates 15% to high yield bonds.
This fund will behave very differently from one that is truly
investment grade only.
Fund #2
Benchmark = Barclays U.S. Universal, BofA ML 3-Month U.S. Treasury Bill Index
Effective Duration = 2.43 years
(% Notional
Exposures)
Cash
Agency Pass-Thru MBS
Net Derivatives
Emerging Markets
Non-U.S. Sov. Related
Commercial Mortgages
Asset Backed Securities
IG Index Credit Der.
Non-Agency Mortgages
HY Index Credit Der.
Even more confusing are less specific terms like “strategic
income.” Traditionally, these types of funds invest in investment
grade, high yield and emerging market debt, and were a more
aggressive type of bond fund. They are most commonly found in
the Morningstar Multi-Sector Bond Fund Category. Today, the
term is also used by funds that are in the Nontraditional Bond
Fund Category, make very active bets and are benchmarked
to cash. The sample sector allocations in Exhibit 3 all include
“strategic income” in their names, but are quite different.
Non-U.S. Credit Related
High Yield
Other
Bank Loans
IG Industrials
Taxable Municipal Bonds
IG Financials
IG Utilities
Non-U.S. Idx. Credit Der.
Agency CMOs
3.5%
3.3%
3.0%
1.6%
0.9%
0.6%
0.4%
0.3%
0.2%
0.0%
5.2%
Equity
-0.2%
U.S. Interest Rate Der.
5.0%
-6.7%
Municipals
4.4%
Treas. and Treasury
Futures
Non-U.S. Interest Rate
Der.
CLO Securities
4
18.0%
16.0%
9.0%
8.2%
7.3%
7.2%
5.7%
5.6%
5.6%
5.3%
(% Notional
Exposures)
-9.6%
Beyond Duration: Comparing Taxable Bond Funds
August 2016
▪▪ Cash benchmark and very short duration signal more
absolute return approach.
▪▪ Heavy derivative use long/short indicates different
type of strategy.
▪▪ Probably not suitable for a large portion of fixed
income allocation.
Fund #3
Benchmark = Barclays U.S. Aggregate Bond Index
Effective Duration = 5.52 years
Sector Allocation
Investment Grade Credit
39.1%
High Yield Credit
33.0%
Preferred
8.4%
Emerging Market Debt
5.0%
Commercial Mortgage-Backed
4.8%
Mortgage-Backed
3.9%
Nondollar-Denominated Bonds
3.7%
Other Sectors
1.2%
Cash and Equivalents
1.2%
Asset-Backed
0.7%
U.S. Treasury/Agency
0.0%
Other
-0.8%
▪▪ Typical broad bond benchmark and intermediate-term
duration signal more mainstream approach.
▪▪ More traditional multi-sector bond fund with larger
allocations to higher yielding sectors.
▪▪ May be suitable for a larger portion of fixed income allocation.
Understanding May
Breed More Suitable Portfolios
Bond funds are sometimes considered a sleepy, boring category,
but they are actually subtly complex with distinct strategies.
Understanding the diversity and varying approaches of funds,
even in the same category, can help create a portfolio better
suited to an investor’s unique needs and goals. ▪
5
Beyond Duration: Comparing Taxable Bond Funds
August 2016
For more information, please consult with your financial advisor and visit nuveen.com.
An agency collateralized mortgage obligation (CMO) is a mortgage-backed security divided
into categories based on risk and maturity dates. It involves pooling mortgages into a special
purpose entity, where different tranches of the securities are then sold to investors. Agency
refers to securities guaranteed by Ginnie Mae, an agency of the U.S. government, or by US.
Government-sponsored enterprises (GSEs), such as Fannie Mae or Freddie Mac.
An agency pass-through MBS is a security based on a direct ownership inters in a pool of
mortgage loans. A servicing intermediary collects the monthly payments from issuers, and, after deducting a fee, remits or passes them through to the holders of the pass-through security.
Agency refers to securities guaranteed by Ginnie Mae, an agency of the U.S. government, or by
US. Government-sponsored enterprises (GSEs), such as Fannie Mae or Freddie Mac
An asset backed security (ABS) is a financial security backed by a loan, lease or receivables
against assets other than real estate and mortgage-backed securities.
A collateralized loan obligation (CLO) is an investment-grade bond backed by a pool of junk
bonds. Junk bonds are typically not investment grade, but because they pool several types of
credit quality bonds together, they offer enough diversification to be “investment grade.”
A commercial mortgage-backed security (CMBS) is a mortgage-backed security that is
secured by the loan on a commercial property.
A convertible bond can be converted into a predetermined amount of the company’s equity
at certain times during its life, usually at the discretion of the bondholder.
A credit relative value strategy seeks to exploit pricing discrepancies between individual
securities or market sectors.
A derivative is a security in which the price depends on one or multiple underlying assets.
Common derivatives include forward contracts, futures contracts, options and swaps. Conversely, swaps are just one type of the entire asset class.
INDEX DEFINITIONS
The Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered,
taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond
market, with index components for government and corporate securities, mortgage pass
through securities and asset-backed securities.
The Barclays Intermediate Aggregate Bond Index covers the U.S. investment grade fixed
rate bond market, with index components for government and corporate securities, mortgage
pass through securities and asset-backed securities with maturities of 1 to 10 years.
The Barclays Intermediate Government/Credit Index is an index of investment-grade
government and corporate bonds with a maturity rate between 1 and 10 years.
The Barclays Corporate A-Rated Index is the A-rated component of the Barclays U.S.
Corporate Investment Grade Index, which includes publically issued U.S. corporate debt and
specified foreign debentures and secured notes that are SEC-registered.
RISKS AND OTHER IMPORTANT CONSIDERATIONS
Investing involves risk; principal loss is possible. Debt or fixed income securities are subject
to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk
and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield
debt securities are subject to liquidity risk and heightened credit risk. Preferred securities are
subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including
currency fluctuation, political and economic instability, lack of liquidity and differing legal and
accounting standards. Asset-backed and mortgage-backed securities are subject to additional
risks such as prepayment risk, liquidity risk, default risk and adverse economic developments.
This information represents the opinion of Nuveen Asset Management, LLC and is not
intended to be a forecast of future events and this is no guarantee of any future result. It is not
Duration is expressed in years. It is calculated by dividing the sum of the present value of each
coupon payment multiplied by the time until the payment is received by the price of the bond.
A high yield bond (HY) is a high paying bond with a lower credit rating than investment-grade
corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default,
these bonds pay a higher yield than investment grade bonds.
An investment grade bond (IG) carries a rating that indicates that a municipal or corporate
bond has a relatively low risk of default.
A mortgage backed security (MBS) is a type of asset-backed security that represents the
amount of interest in a pool of mortgage loans.
A non-agency residential mortgage-backed security (MBS) is a mortgage-backed
security that is not guaranteed by Ginnie Mae, an agency of the U.S. government, or by US.
Government-sponsored enterprises (GSEs) such as Fannie Mae or Freddie Mac. These securities
are the sole obligation of their issuer and assigned credit ratings by independent credit rating
agencies based on their structure, issuer, collateral and any other guarantee factors
A preferred security is a class of ownership in a corporation that has a higher claim on its
assets and earnings than common stock. Preferred shares generally have a dividend that must
be paid out before dividends to common shareholders, and the shares usually do not carry
voting rights.
SEC 30-day yield is a standard yield calculation developed by the Securities and Exchange
Commission (SEC) that allows for fairer comparisons of bond funds. It is based on the most
recent 30-day period covered by the fund’s filings with the SEC.
A swap typically refers to an interest rate swap, which is an agreement between two parties
where one steam of future interest payments is exchanged for another based on a specified
principal amount. Interest rate swaps often exchange a fixed payment for a floating payment
that is linked to an interest rate (most often the LIBOR).
The Barclays Corporate BBB-Rated Index is the BBB-rated component of the Barclays U.S.
Corporate Investment Grade Index, which includes publically issued U.S. corporate debt and
specified foreign debentures and secured notes that are SEC-registered.
The Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, U.S.
Corporate High-Yield, Investment Grade 144A Index, Eurodollar Index, U.S. Emerging Markets
Index, and the non-ERISA eligible portion of the CMBS Index. The index covers USD- denominated, taxable bonds that are rated either investment-grade or below investment-grade.
The BofA Merrill US 3-Month Treasury Bill Index is comprised of a single issue purchased at
the beginning of the month and held for a full month. At the end of the month the issue is sold
and rolled into a newly selected issue. The issue selected at each month-end rebalancing is the
outstanding Treasury Bill that matures closest to, but not beyond, three months from the rebalancing date. To qualify for selection, an issue must have settled on or before the month-end
rebalancing date. While the index will often hold the Treasury Bill at the most recent 3-month
auction, it is also possible for a seasoned 6-month Bill to be selected.
intended to provide specific advice and should not be considered investment advice of any
kind. Information was obtained from third party sources which we believe to be reliable but are
not guaranteed as to their accuracy or completeness. This report contains no recommendations
to buy or sell specific securities or invest-ment products. All investments carry a certain degree
of risk, including possible loss of principal, and there is no assurance that an investment will
provide positive performance over any period of time. It is important to review your investment
objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen
Investments, Inc.
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GLOSSARY