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Morningstar's New Corporate Bond Category for CEFs

Cara Esser

On Nov. 4, Morningstar launched new categories for open-end, closed-end, and exchange-traded funds. (In Friday's article, we highlighted the new preferred stock category). The corporate bond category was created to cull funds from the intermediate- and long-term bond categories that focused on corporate bonds. Morningstar decided that they were sufficiently different from their intermediate- and long-term bond peers to justify pulling them out of those groups and forming a new category.

The new corporate bond category contains funds with average durations that are intermediate to long term and have typically invested at least two thirds of their portfolios in corporate bonds over a three-year period. With the new category, investors interested in corporate bond exposure can more easily pinpoint funds concentrated in the sector. For example, Invesco Bond Fund (VBF), whose mandate requires at least 80% of assets be invested in U.S. investment-grade corporate bonds, was lumped with AllianceBernstein Income (ACG), a fund that invests heavily in long-term U.S. Treasury bonds (63% as of June 2013) under the previous categorization rules.

Though correlations of the corporate bond category and both the intermediate- and long-term bond categories have been increasing over the years (see Table 1 below), strategies focused primarily on government bonds (a hallmark of many of the CEFs left in the Intermediate- and Long-Term Bond categories) are unlikely to act similarly to funds focused on corporate bonds given their differences in credit quality. Prices of government and related bonds should react more readily to shifting interest rates than investment-grade corporate bonds where credit risk also has an impact on their prices.

More recently for these three categories of CEFs, there have been big dispersions in market price and net asset value returns as investors have become more concerned with rising long-term interest rates. For example, during the second quarter of 2013, the average NAV decline for funds in each category was between 3% and 5%, while the average share price loss was 7% for corporate bond funds, 6% for long-term bond funds, and 5% for intermediate-term bond funds. Note that while investors seemed to over-react within the corporate bond category in the second quarter (Fed tapering, after all, should mean the economy is getting stronger, which is good news for corporations and their ability to pay back debt), the share prices of those funds dropped an average of just over 1.0% in the third quarter, compared with nearly 5.0% for long-term bond funds and 1.5% for intermediate-term bond funds.

Corporate Bond CEFs
Table 2 below lists the 10 CEFs comprising the new corporate bond category. Discount and valuation data, leverage ratios, and distribution rates are also included. Only one fund currently has a Morningstar Analyst Rating: BlackRock Credit Allocation (BTZ) is rated Neutral as of this writing.

Though none of the funds are sporting valuations that are extremely enticing, wider-than-average discounts remain the norm for this group. The funds' already alluring distribution rates (some juiced by leverage) look even better taking their current discounts into account. As the market continues to grapple with Fed policy and the expectation of rising interest rates, investors may have more opportunities to pick up shares at advantageous prices, boosting distribution rates further. Of course, leveraged exposure to any sector, even the seemingly benign investment-grade corporate bond universe, leaves investors exposed to added volatility of returns. These funds can play a valuable role in a well-diversified portfolio but should not make up a portfolio's core exposure to fixed income.

Cara Esser does not own shares in any of the securities mentioned above.