What Morningstar’s category split means for bond investors
04 mins 36 secs
“What Morningstar’s category split means for bond investors”
Apu Sikri: Mike, do you want to recap what has happened with Morningstar and where we are with that category today, the intermediate bond category, which is the largest category — or was?
Mike Gitlin: Yeah, it's a great question, Apu. And it's a really meaningful change. So the intermediate bond category became a bit of a catch-all, where there were some funds in that category with zero high yield and some funds in that category were 20% high yield. They will have very different outcomes for clients in very different environments.
And Morningstar did a great job of splitting that category, basically in half. And it's a $1.6 trillion category. So why it's really important, as well, is it's four times larger than the next bond category. They split intermediate bond into core and core-plus. And core is anything where you effectively have less than 5% high-yield exposure — basically saying, “Own the core; it is the balance in your portfolio.” And core-plus will probably be a much smaller portion of folks’ portfolios because it creates a little more uncertainty when you have higher yield and higher correlation to the equities.
So that really should clarify for end investors and for advisors that there are risks in the bond market, and you need to be very aware of those risks. It's splitting that category into knowing what's core to my portfolio and where am I going to get my plus from?
Apu Sikri: What is your view of these changes?
Mike Gitlin: So my view is, this was a critical message to both advisors and clients. What it's saying is, not all intermediate bond funds are created equal. Yes, there's a benchmark duration of around 5-1/2 years, but the credit risk that many of these funds take can be very, very different. And so I think that the core category will end up being the largest bond portion of a balanced portfolio. And it should be, because what that will do is provide what you need in a fixed income portfolio.
A core portfolio will provide diversification from equities, capital preservation, income and often can provide inflation protection, which we refer to as the four roles of fixed income in a balanced portfolio. The core portfolio should be able to provide that with much less volatility than you'll see from the core-plus category.
Apu Sikri: When you discussed this with Morningstar — they canvassed a bunch of you from different managers — what was your conversation like, and what is their thinking from what you've assessed of it?
Mike Gitlin: Yeah. We've been advocating for this change for some time, in that it's just a clearer blueprint for folks looking at the category. It doesn't mean core-plus is bad, necessarily. It just means folks who own core-plus funds now should understand that those funds are going to have a higher correlation with the equity market. And they should know that core, when there's a risk-off environment in equities, should be the ballast in their portfolio.
So we've been advocating this, Morningstar's been listening, and we really think they made the right decision to split this. It's a perfect guide for the advisor to understand the category changes now.
Apu Sikri: What implications does that have for advisors who manage fixed income on behalf of their clients? How should it inform portfolio positioning, portfolio construction, asset allocation? What would you say if an advisor asked you?
Mike Gitlin: Well, it's telling that seven of the largest 10 active funds got put into core-plus. That's an interesting note. And what that says is those funds own meaningful high-yield exposure. So those funds necessarily would have a higher correlation to the equity market than core funds, which own less high-yield exposure.
And what I would say is, that tells you — as both the end client and the advisor — “where do I want my high-yield exposure?” I'd argue you should get that in dedicated high yield. You always know what it is, and you know it's 100% high yield. You know it's going to be correlated to the equity market. You know through a full cycle, you'll likely do quite well, but you also know there's greater risk in that than investment grade.
And so it says, “Have my core be the core of my bond portfolio. I can have some core-plus, but I should have less core-plus than core. And I'll have my dedicated high yield where I know exactly what to expect in different market environments.” I think this a real clear guide in terms of risk exposure.
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Morningstar’s recent splitting of the intermediate bond fund category will have an immediate impact on bond investors, says head of fixed income Mike Gitlin. At issue: credit risk.