How do the new Morningstar bond categories affect you?

Fixed-income markets experienced a fairly big change on April 30, and for once it had nothing to do with interest rates or central banks. We’re talking about Morningstar’s decision to divide the intermediate-term bond category—one of the largest in terms of assets—into two new categories: intermediate core bond and intermediate core-plus bond. The implications for investors could be significant.

Funds in the intermediate-term bond category tended to cluster in two main groups: those that stuck closely to investment-grade bonds and those that held larger positions in below-investment-grade debt, emerging-market debt, and other, riskier areas of the market. Since the performance profile of these two groups can vary widely in different market environments, Morningstar’s category change is designed to “provide investors with clearer expectations for risk and performance and to create more homogeneous categories.” ¹

Specifically, Morningstar defines the intermediate core bond category as having funds that invest primarily in investment-grade U.S. issues, including government, corporate, and securitized debt, and typically hold less than 5% in below-investment-grade exposures. Intermediate core-plus bond funds also invest in those sectors but have greater flexibility to hold noncore sectors such as corporate high yield, bank loan, emerging-market debt, and non-U.S. currency exposures. Both groups still have average durations that range from 75% to 125% of the three-year average duration of the Morningstar Core Bond Index.

One of the first things investors may notice is a change in the Morningstar ratings of the funds they own in either of these new categories. The reason is that the funds are being compared against a new and smaller competitive set. For example, a strictly investment-grade bond fund may have held a lower rating before when compared against funds that were rewarded for taking more risk. Today, that higher-quality fund will be compared against funds that are more similar.

According to Morningstar, the core-plus bond category has roughly 190 open-end funds and exchange-traded funds (ETFs) totaling around $720 billion in total assets; the core bond category holds about 140 funds and ETFs totaling roughly $830 billion. ¹

Our review of advisor model portfolios over the past year reveals a few items worth considering now that the Morningstar categories have changed. ²

• Review your funds’ ratings—It’s safe to say that most advisors will feel the impact of this shift in categories. Three-quarters of all the financial advisors our portfolio consulting team worked with over the past 12 months had client assets invested in the old intermediate-term bond category. If you’re one of those advisors, now may be a good time to see how the change has affected ratings and relative risk metrics.

• Check overall asset allocation—The fact that 25% of advisors did not have any exposure to the intermediate-term bond category suggests some may be overlooking a fundamental position in client portfolios. Intermediate-term bond funds have the potential to add ballast to a portfolio in situations where either equities are underperforming or when interest rates are rising, both of which have occurred over the past year.

• Take a closer look at your intermediate-term bond funds—Many advisors naturally assumed that by adding exposure to the intermediate-term bond category, they were adding core bond exposure for their clients. Our analysis of advisor model portfolios showed that many intermediate-term bond positions were often paired with short duration and credit-focused bond funds. What these advisors may not have realized was that many intermediate-term bond funds already had core-plus attributes (lower credit quality sleeves and the inclusion of satellite asset classes). In fact, of those advisors who had client assets invested in the old intermediate-term bond category in 2018, we found that a full 70% owned only funds that are now considered core plus. This suggests that some advisors may be taking on more risk than they intend with what amounts to a core portfolio position. 

“… of those advisors who had client assets invested in the old intermediate-term bond category, we found that a full 70% owned only funds that are now considered core plus.”

With investment-grade yields so low in recent years, it’s understandable that financial advisors would have gravitated toward funds in the intermediate-term bond category that included high yield and other satellite bond sleeves. Today’s late-cycle environment presents a somewhat different set of risk/return trade-offs, however. Interest rates are higher, growth is less robust, and a growing consensus of economists believes that the U.S. Federal Reserve’s next rate change will be lower. The question going forward is whether a strong preference for riskier bond assets will enable clients to take advantage of what comes next for the economy and monetary policy. 

1 Morningstar, “Introducing Two New Morningstar Fund Categories,” May 2, 2019.

2 Portfolio Consulting Team review of 272 portfolios from April 1, 2019, to May 15, 2019.