A recent investment industry trade report noted that roughly half of all U.S. financial advisors had increased exposure to emerging market bond portfolios this year. And wouldn't you know it, emerging market bond funds are down 10 percent since the beginning of May.
As investors and financial advisors have extended credit risk to make up for the relatively unattractive U.S. bond market, high-yield bonds and emerging market bonds, in particular, have been attracting a majority of the bond fund flows.
Vanguard Group recently had to close a high-yield bond fund to new investors because of the flood of assets into the fund. Mutual fund companies are not showing any signs of slowing down in marketing more exotic bond portfolios, either.
A Legg Mason fund official told CNBC on Thursday that emerging market bond funds are the place to be. Vanguard, considered the "investor's best friend" among more marketing-oriented mutual fund companies, launched its first emerging market bond fund last week.
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With emerging market bond funds down 10 percent in the past month and a half, is this really the time to be jacking up exposure to a volatile asset class?
Yes, and no.
There is always a place for global diversification in a bond portfolio. In fact, a bond portfolio should be properly diversified regardless of where the "hot" money is going.
It should also be diversified based on your age, risk horizon and financial needs. But the recent turmoil in the bond markets coupled with the prevailing trend among investors to stretch for yield could make an investor lose sight of these primary investment decision-making triggers.
"You live by the sword, you die by the sword," said financial advisor Rick Ferri, founder of Portfolio Solutions. Ferri said advisors who think they can pick sectors are advisors whom clients should leave.
And bonds are slaying investors and likely giving grief to yield-chasing financial advisors right now. Investors pulled out record amounts from high-yield and emerging-market debt funds in the past week, according to new data from Lipper. A continued exodus from high-yield products drove the redemptions; high-yield mutual funds and ETFs pushed out $3.3 billion for the week. Yet investors continued to allocate new cash to bank loan products, adding $1.4 billion.
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For investors unsettled by the unrest in the bond markets and the performance slide in emerging market bonds in particular, here are five questions you need to ask your advisor, and of yourself. You'll probably find that amid volatility, reverting to core principles of investing and risk are the best benchmark for action.
1. Should I shorten up on bond duration or just sell everything?
Investors are shortening up on bond duration, and as Bob Pisani pointed out in a blog post on Thursday, there's a quantifiable explanation: The iShares Barclays 1-3 Year Credit Bond Fund (CSJ), a short-term corporate bond ETF, has dropped much less than the iShares 10 Year Credit Bond Fund (CLY), a long-term corporate bond ETF.
The CLY has dropped 9 percent since May 1, the CSJ only 0.4 percent. The downside: Very little potential for appreciation and tiny yields—about 1.4 percent in the case of the CSJ. Some financial advisors prefer a strategy of replacing bonds entirely, and point to the fact that the yield on short-duration bond funds is not any better than the yield on some bank CD products.
If you're shortening up on duration, the real question is, what is duration of your liabilities? Will you be retiring 20 years from now or are you 80 years old? The duration of your liabilities should dictate whether you should fear current volatility in bond market.
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Do you need money now or in the next year? Then you shouldn't have had so much risk in your bond portfolio to begin with. If you have kids going to college next year or a wedding to pay for or a tax liability, you would have good reason to be concerned, but you should have been concerned much earlier.
2. What about the bank loan asset class?
Senior bank loans may sound like they are investment grade bond risk, but to many financial advisors, like Ferri, they are just junk bonds by another name. "It's a fallacy to think that buying a bank loan fund is a way to get a safer, higher-yield investment," he said.
The bank loan funds don't have the interest rate risk that continues to be tied to the quantitative easing talk—talk about QE being ended. But consider this: The much-feared inflation that was supposed to occur with QE has not happened, and interest rates don't necessarily go higher if there is no rise in inflation, Ferri said.
Allan Roth, founder of Wealth Logic, said: "Top economists have less than a 50 percent track record in predicting rates. … Experts' ability to time rates is horrible.The bottom line is we don't know."
"Interest rates have already gone up. The question is, where are they going from here? You don't know," Ferri said.
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3. Are emerging market bonds the answer, and I should stick with them?
Investors and their advisors have been piling on risk and if they haven't been aware of the volatility that could result from those actions, then they haven't been thinking about the basics of diversification. Fund companies and advisors may say you need to have emerging market exposure for "diversification" but there's a difference between adding diversification and just adding more risk.
Jack Bogle, founder of the Vanguard Group, told The Wall Street Journal last week when Vanguard announced the emerging market bond fund: "I would think that investors should be very cautious about taking extra sovereign risk. I like to take my risk on the equities side."
You don't convert an investment-grade bond holding to emerging market bonds because you think it's the right "diversification" move. Any investor around for the Mexican default in the early '90s or the Russian default and Long-Term Capital Management knows that the volatility is enormous in this asset class.
Consider that emerging market bond funds are down 10 percent in the past month and a half without one default occurring. "If you understand the risk, it could be down 20 percent easily, and that's to get your 5 percent yield," Ferri said.
The answer is a diversified bond portfolio that meets your investment and risk objectives and your life situation. Having an allocation to riskier credit isn't in and of itself a problem, even when that asset class is experiencing a short-term crash. For example, say you have had a fixed allocation to high-yield bonds for 15 year of 20 percent. When it has a great run, you don't add to it, but sell it to rebalance the portfolio.
4. Should I switch from passive to active bond fund management?
Going active will ensure only one thing: you will pay more in fund expenses. You will also likely be taking more risk as the bond manager makes bets on duration, credit and sectors. The long-term performance data on active bond management mirror the data on the equity side: Picking the minority of bond fund managers who will outperform in the future is no easy task. Bond index funds outperform the average active bond fund over the long term 80 percent of the time.
5. Is the recent volatility in the bond market here to stay? Is volatility a bad thing?
If you are investing in riskier bond asset classes like emerging market bonds, the answer is yes. It doesn't matter if you think South Korea is not an "unstable" emerging market, like "those other ones." Emerging market bond funds are by nature, volatile. As Pisani noted in his blog Thursday, If you look at the main emerging markets ETF, iShares MSCI Emerging Markets Index Fund, it has routinely swung in a 25 percent range every six months for the past several years.
—By CNBC.com's Eric Rosenbaum.