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“Core” vs “Core-Plus”: Understanding the New Bond Fund Categories

In May, Morningstar made an adjustment to its largest bond fund category. The “intermediate-term bond” category was retired and broken into two new separate categories: “intermediate core bond” and “intermediate core-plus bond.”

This has important ramifications for investors, because core bonds are often the building blocks of a well-diversified portfolio. Core bonds provide what stocks and aggressive income investments often do not: greater stability and liquidity.

The categories may sound similar, but they have some key differences. Most importantly, the “plus” in core-plus can mean higher yields, but also higher risks.

Why the change?

Prior to the change, funds in the intermediate-term bond category generally invested in investment-grade government and corporate bonds with average durations in the three-and-a-half to six-year range.

However, many funds in this category would explore other fixed income investment options, like international bonds or some bonds with sub-investment grade credit ratings. This meant that the risk profile within the “intermediate-term bond” fund category was relatively wide, with many funds focusing on more high-quality investments, while others included higher-risk securities.

The new definitions of the categories are as follows:

  • Intermediate core bond portfolios invest primarily in investment-grade U.S. fixed-income issues, including government, corporate and securitized debt, and typically hold less than 5% in below-investment-grade exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index. 1
  • Intermediate core-plus bond portfolios invest primarily in investment-grade U.S. fixed-income issues, including government, corporate and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loans, emerging-markets debt and non-U.S. currency exposures. Their durations typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.1

Having two categories allows investors to get a better idea of how much risk a fund may be taking. That’s important given the size of the “core bond” market. Prior to breaking the categories in two, the intermediate-term bond fund category held far and away the most net assets, and with a large number of funds. With so many options to choose from, it was difficult to filter out the lowest-risk or the highest-risk funds. The two new categories still rank numbers one and two in terms of total net assets for all bond fund categories, by a wide margin.

 Core and core-plus bond funds still have the largest amount of assets

Even after breaking the categories in two, total assets in core and core-plus funds dwarf the next largest group categories. The intermediate core bond category has more than $752 billion in assets, while intermediate core-plus has roughly $702 billion.

Source: Morningstar Direct, as of 6/30/2019  For illustrative purposes only, not a recommendation.

Core vs. core-plus: key differences

There are a few key differences between core funds and core-plus funds, but keep in mind that within each category, the asset allocations of each fund can vary significantly. While our discussion below focuses on average characteristics for funds within each category, no two funds will be the same. When considering any investment for your portfolio, look at the actual characteristics of the fund being considered, not just its category.

There are three key differences to highlight:

1. Credit ratings. A key difference between the two categories is the amount of sub-investment-grade bonds that can be held. Per the Morningstar definition, core bond funds typically hold less than 5% of their investments in sub-investment-grade debt. Core-plus funds have more flexibility to invest in lower-rated bonds.

As this chart illustrates, core-plus funds do have a slightly more aggressive credit rating tilt, leaning slightly more toward the sub-investment-grade and non-rated end of the spectrum. Put more simply, the average credit rating of the holdings within core funds is “A,” while the average credit rating of the holdings in core-plus funds is “BBB,” according to Morningstar Direct.2

Core bond funds generally invest in higher-rated bonds than core-plus funds do

On average, intermediate core bond funds hold 94.8% in investment-grade bonds, versus 88% for intermediate core-plus bond funds. Core bond funds have 3.7% sub-investment-grade bonds, on average, compared with 8.8% in core-plus funds.

 

Source: Morningstar Direct, as of 5/31/2019. Credit ratings represent the average ratings of all mutual funds and ETFs within the two fund categories. For illustrative purposes only, not a recommendation.

2. Types of bonds. Per the Morningstar category definition, core-plus bond funds have greater flexibility to hold more non-core sectors, like bank loans, emerging-market bonds or non-U.S.-dollar-denominated debt. Core bond funds, on the other hand, invest primarily in U.S. government, corporate or securitized debt. However, the differences in the types of bonds that each category holds is not very wide.

3. Risk and return potential. Core-plus bond funds offer the potential for higher yields and higher total returns by boosting their exposure to lower-rated and more niche fixed income investments. But that greater return potential is accompanied by increased risks.

Over the past five-, 10- and 15-year periods, the average annualized total returns of core-plus funds have been higher than those of core funds, as the chart below illustrates. Core-plus funds were generally more volatile, however—over each of those investing horizons, core-plus funds had higher annualized standard deviations than core funds.3

With higher allocations to lower-rated or niche investments, core-plus bond funds could underperform core bond funds if the economy slows or enters a recession, or if the stock market declines. For example, in the fourth quarter of 2018, when the S&P 500® index suffered a nearly 20% drop, core bond funds generally outperformed core-plus funds. In the last three months of the year, the average total return of core funds was 0.87%, compared to an average total return of 0.65% for core-plus funds.4

Core-plus funds have, on average, outperformed core funds over various investing horizons

Intermediate core bonds had 5-year, 10-year and 15-year returns of 2.6%, 3.9% and 4%, respectively. Intermediate core-plus bonds had 5-year, 10-year and 15-year returns of 2.8%, 4.8% and 4.4%, respectively. 

Source: Morningstar Direct, as of 6/30/2019. Total returns assume reinvestment of interest and capital gains. Total returns represent average total returns of all funds in the given fund categories, and are not representative of a single fund or index. Past performance is no indication of future results.

 

What to consider now

Core bond funds and core-plus bond funds are still very similar, despite the headlines. Although core-plus funds do have greater exposure to some riskier segments of the bond market, they’re still mostly composed of highly rated, lower-risk investments.

For investors who previously owned an “intermediate-term bond” fund that has now been re-categorized as a core-plus fund, make sure that the slightly higher risk profile is in line with your investment goals and objectives. For investors who prefer strictly high-quality bonds, an intermediate-term core bond fund might be more appropriate than a core-plus fund.

 

1 Source: Morningstar Inc,, “Introducing Two New Morningstar Bond Categories,” 05/02/2019.

2 As of 05/31/2019.
3 Standard deviation is a measure of volatility or risk. The higher the standard deviation, the more volatile the investment.

4 Source: Morningstar Direct, using monthly total returns from 9/30/2018 through 12/31/2018.
 

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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