Core vs. Core Plus: Do You Know What You Own?

By Douglas Gimple
June 2019
  • As financial markets have evolved and become increasingly complex, the number of products available to investors has grown. However, the mainstay of asset allocation, core fixed income, has not changed.
  • Recently, Morningstar created two new categories, Core Bond and Core Plus Bond, to account for the differences in these strategies. Despite this change, performance measurement remains an unresolved issue.
  • We believe it’s important to understand what you own in your bond portfolio, as it’s designed to provide some stability in your portfolio during periods of market uncertainty.

Analogies are frequently used in the investment industry to communicate complex theories and processes to investors. One of the most commonly used analogies is a toolbox, illustrating to investors the variety of tools with which they can achieve their investment objectives. In the early days of investing, the toolbox was limited, focusing on a mixture of equity and fixed income products to deliver a range of returns based on investors’ risk tolerance. As financial markets evolved and became increasingly complex and more accessible to everyday investors, the toolbox expanded to include products such as leveraged loans, real estate, private debt, hedge funds, derivatives, and currency overlays. There have also been changes to the original components of the asset allocation model, with equities evolving into numerous options and fixed income now encompassing high yield, emerging market debt, and international debt strategies. However, the mainstay of asset allocation, core fixed income, which is meant to deliver stability and predictability in uncertain economic markets, has not changed.

Core Bond and Core Plus: What Makes Them Different?

On April 30, 2019, the Intermediate-Term Bond Morningstar category was replaced with two new categories: Core Bond and Core Plus Bond. Strategies in both categories primarily invest in investment-grade U.S. fixed income securities including, but not limited to, government, corporate, and securitized debt. The main difference between core and core plus strategies is the allocation limit for below-investment grade securities, as core strategies cannot invest more than 5% in below-investment grade securities. On the other hand, core plus strategies have great flexibility in this portion of the market and can invest in non-core sectors including high yield corporate debt, bank loans, emerging markets debt, and non-U.S. currency exposures.


Source: Morningstar Direct.


Source: Morningstar Direct.

Same Benchmark, Different Investable Universe

While the recent creation of two separate categories by Morningstar is a welcome advancement and provides clarity around core and core plus strategies, performance measurement remains an unresolved issue. Both categories utilize the Bloomberg Barclays U.S. Aggregate Index as their standard benchmark, even though Core Plus strategies utilize areas of the market that are not included in the Aggregate Index. Core strategies are mandated, for the most part, to invest only in investment-grade securities, with some flexibility for securities that are downgraded after purchase. Core Plus managers can utilize a variety of levers outside of the Aggregate Index, including emerging market debt, high yield bonds, currency trades, and leveraged loans, which can lead to dispersion from the Aggregate Index and create significant periods of underperformance or outperformance.

The Bloomberg Barclays U.S. Universal Index incorporates some of the “plus” sectors. However, the Universal Index is infrequently used by core plus managers, with only four funds in the Core Plus category utilizing this Index. Additionally, while the Universal Index incorporates some of the “plus” sectors, it underrepresents them relative to the investable universe for core plus managers. For example, the high yield component comprises less than 5% of the Universal Index, while high yield can comprise up to 20-25% of some core plus strategies. Emerging market debt is another example, as it makes up less than 3% of the Universal Index but can be a sizable allocation in a core plus strategy. While it is not the best solution for benchmarking performance for core plus strategies, the Universal Index is a more appropriate option for core plus strategies than the Bloomberg Barclays U.S. Aggregate Bond Index.

It’s Not the Destination, It’s the Journey

By comparing core and core plus strategies, our intent is not to disparage core plus strategies, but rather to raise awareness of the differences between the two styles. Prior to the Financial Crisis, there was a significant increase in the allocation to core plus managers, as well as an increase in core managers allocating to plus sectors, as investors looked to pick up whatever additional yield they could in an environment with compressed spreads and minimal volatility. As illustrated in the chart on page 3, in 2008, the return for the Morningstar Core Plus category was negative 4.89%, while the return for the Core category was 0.73%. Markets and spread sectors rebounded in 2009, with Core Plus delivering 15.13% and Core generating 11.46%. For the two-year period covering 2008 and 2009, Core Plus and Core were in line with one another, generating 5.50% and 5.48%, respectively. But, for most investors, it’s not the destination, it’s the journey.

In 2008, the S&P 500 declined 37%, with most of the negative performance occurring in the fourth quarter. In fact, the S&P 500 lost nearly 22% during the fourth quarter of 2008 as the Financial Crisis accelerated, while the Core category increased 1.39% and Core Plus category decreased 0.94%. In times of significant stress on the equity markets, investors should be able to look to their fixed income allocation to deliver some stability due to the uncorrelated nature of the investments. This was not the case for core plus investors in 2008 when the median strategy in the Core Plus category was down 4.89%, with some managers down double digits. Core investors derived some stability from their investment-grade allocation with a Core category return of 0.73%, helping to mitigate losses experienced in the broader market.


Core Bond and Core Plus Bond Calendar Year Returns

Source: Morningstar Direct.

More recently, the fourth quarter of 2018 was a period of significant volatility that roiled the equity market and, once again, core fixed income served to stabilize, rather than contribute to, the overall angst in the marketplace. The S&P 500 declined 13.52% during the fourth quarter of 2018, while the Morningstar Core Plus and Core categories returned 0.64% and 1.37%, respectively. As the market rebounded in the first quarter of 2019, the S&P 500 reversed course, returning 13.65%, while the Core Plus category returned 3.44% and the Core category returned 2.93%. Once again, it was more about the journey than the destination, as strategies in the Core and Core Plus categories delivered very similar returns over this two-quarter period, returning 4.08% and 4.34%, respectively.

One method of measuring the relationship between equity and fixed income strategies is to examine the correlation. Comparing the Morningstar Core category to the S&P 500, investors can see that an allocation to core fixed income maintains a negative correlation to the equity markets over long periods of time, meaning that the two strategies move in opposite directions from a return standpoint. When examining the relationship between the Morningstar Core Plus category and the S&P 500, the correlation is positive, meaning that the returns for the two strategies have moved in the same direction, though to varying degrees.


Source: Morningstar Direct.

Know What You Own

As we learned during the Financial Crisis, and more recently in the fourth quarter of 2018, it is incredibly important to understand what you own in your bond portfolio. If your core allocation (or overall fixed income allocation) consists of a mix of derivatives and leverage, it can create layers of uncertainty for advisors and investors alike. We believe that transparency is key in your core bond portfolio, which is meant to serve as the ballast in your asset allocation, similar to how water is used to improve the stability and control of a ship. Again, this is not to say that a more complex and opaque fixed income product doesn’t have a place in an overall asset allocation. Rather, a decision must be made to either employ a core plus strategy as an overall fixed income allocation, accepting the inherent risks that come with investing in non-benchmark areas of the market in place of a traditional core allocation, or rely on a style-pure core bond portfolio that provides negative correlation to equities and remains true to the performance objective around which one can build satellite allocations.

The views expressed are those of Diamond Hill as of June 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

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