Late into economic recoveries we see a typical pattern emerging. Central banks have lowered rates to encourage economic recovery. Asset markets have recovered, leaving investors feeling more confident about investment risks. Investors, dissatisfied with falling yields, start to look for more income. In their search, they begin to ramp up the risk of their fixed income portfolios. These investors rationalize seemingly harmless decisions for an extra 1% of yield. They extend the maturities of bonds, increasing interest rate risk. They buy lower rated credits, increasing volatility and default risk. For a time, all seems merry as credit spreads continue to tighten and interest rates remain subdued.
But nothing lasts forever, and eventually markets change course. Recessions come, making those who extended their credit risk pay the price. Or inflation returns as recoveries pick up, and the central banks start to raise interest rates, causing pain for those who took on more rate risk in their search for yield.
In the last decade there have been two truly spectacular examples of what can happen when these risks rear up for bond investors: Oppenheimer Core Bond and the Oppenheimer Rochester National Municipal fund. (I’m not trying to pick on Oppenheimer, but…)
The performance of Oppenheimer’s Core Bond fund in 2008 is the stuff of legend. The financial crisis was upon us. Banks were reeling. Even high quality, investment-grade corporate debt was struggling as investors ran screaming from anything that wasn’t a US Treasury bond. In 2008 Oppenheimer Core Bond A (OPIGX) fell -35.83%, underperforming the Barclay’s Aggregate Bond index by -41.07% and its Morningstar category average by -31.13%.
This is an investment with the words “Core Bond” in the very title! Investors could easily be led astray and use it as a primary holding in their portfolios. So what happened? The fund was reaching for yield. It loaded up on mortgage debt. Multiple Oppenheimer bond funds had exposure to credit default swaps from Lehman Brothers, AIG and Wachovia. Derivative bets essentially created leverage in the fund, adding extra exposure to risky securities. So, in an effort to juice up returns a bit, investors in the fund got crushed when risk returned.
A more recent example is the Oppenheimer Rochester National Muni fund (RMUNX). Last year serious concerns were raised about the prospects of Puerto Rico’s finances as deficits grew and legacy costs began to be troublesome. Ratings agencies have cut ratings on PR bonds to junk status, and prices have fallen considerably. Many of Puerto Rico’s bonds are owned by national municipal bond funds as the interest is free from federal and state income taxes for the resident of any US state. Mutual fund managers who were looking for a nice yield boost could stock up on Puerto Rican debt. Perhaps owners of RMUNX should not be too surprised by the volatility, given how the fund performed in 2008. But the fund dropped over 10% in 2013 while the broad municipal market lost about 2.5%
The long and short of it is: there is no free lunch when it comes to investing. Whether we’re talking about stocks or bonds, real estate or private equity, if you want higher returns you are going to take on more risk to get them. Don’t mislead yourself into believing that you can boost returns on your bond portfolio without consequence. Know what you own, why you own it, and what role it plays in your portfolio.
Bason Asset Management 