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By Christine Benz | 11-08-2011 12:00 AM

Jacobson's 'Go-To' Noncore Bond Funds

Morningstar's director of fixed-income research offers a checklist for specialty bond shoppers and a few of his personal favorites among the noncore categories.

Christine Benz: Hi, I'm Christian Benz for Morningstar.com.

With bond yields as low as they are right now, many investors are looking to higher-yielding parts of the bond market to give their portfolios more return potential.

Here to talk about how to select noncore bonds and bond funds for your portfolio is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thank you so much for joining me.

Eric Jacobson: Glad to be here, thanks.

Benz: Eric, a lot of investors talk about having core and noncore parts of their bond portfolio. The noncore piece is, I think, the piece that a lot of investors think is going to be the part that will give their portfolio a little bit of extra "get up and go." What types of bond funds would you put under this general noncore umbrella?

Jacobson: Well, I would generally include things like high-yield, any kind of portfolio that invests mostly in non-U.S. securities; emerging-markets bond funds would be there as well. I would even include TIPS, which a lot of people think is probably sort of the core area, but it's not part of what we would call the core space in terms of the broad market. I would throw in, actually, multisector bond funds, which I think a lot of people may substitute as core sometimes, but there are reasons to think of it differently. And relatively the new category that we just launched called Nontraditional Bond, which has the absolute return and unconstrained type strategies in it.

Benz: So, a unifying theme among a lot of these categories is that they are not parts of the bond market that ... a core bond fund ... will necessarily address. So, you may need to be a little bit more surgical, and you'd want to layer on these exposures after you've already obtained that core bond exposure.

Jacobson: Absolutely, I think that's exactly right. One of the things you want to be thinking about is, as you suggest, what is your core fund good at? Not only what does it have in it, but what's it good at?

Benz: So, we also checked that out. I'm assuming you would say, see what that core fund is doing, maybe it has a lot of non-U.S. dollar denominated bonds in the portfolio already, in which case you probably wouldn't want to run out and layer on additional dedicated exposure to that area?

Jacobson: That's exactly right. The opposite case would be, for example, if you went with Vanguard Total Bond Market Index as an example of a plain-vanilla core fund, that's a case where you're not probably going to have any non-dollar exposure and you might want to layer on a foreign bond fund or world bond fund, or perhaps even a little bit of emerging markets.

Benz: Okay. So, let's get right into the red meat portion of the segment. I would like to talk to you, Eric, about what are your favorite highest-conviction names within the noncore space.

Let's start with high yield, which I know over the years has been an area of interest for you. What are the go-to funds for you when you think of the high-yield sector?

Jacobson: Well, one of them that's always been one of my favorites is Eaton Vance Income Fund of Boston. It hasn't been the best performer in the last few years, but it is one that I've liked because of the way that it's tacked back and forth.

Another one that some of my colleagues really like and have covered as well is Fidelity High Income, run by a manager by the name of Fred Hoff, that's one of our group's favorites.

Another I would also mention just to be rounding it out would be T. Rowe Price High-Yield, another perennial favorite.

If I could, let me just throw in a couple of quick extras. These are funds that we're sort of still in the watching phase because they are relatively new compared with some of these others, but ... we have a lot of faith in the teams behind them. And one of them actually is a couple of veteran managers, that's Hotchkis & Wiley High Yield. I think they go by Hotchkis & Wiley High Yield. The ticker is HWHAX, and those are two managers who used to each at different times lead the PIMCO effort. So they've got tremendous history behind them.

And another one is Metropolitan West High Yield, a very good team that we've gotten to know well over the years and that we really like.

Benz: Okay. Now a related category is the bank-loan space, and I know that it's another one that tends to be higher risk, and so should definitely fill this noncore slot as opposed to being a core bond type. Do you have any favorites within that area?

Jacobson: I guess I would couch them this way. For those who want to get into the category but want to be really, really careful relative to what some of the other choices are, I would go for Fidelity Floating Rate. And then for those who want a more straight-up-the-middle fund in terms of really taking on everything that the bank-loan category has to offer, you might consider one of the offerings from Eaton Vance. Honestly, I don't remember the exact name because they've got a few different ones. One of them is Eaton Vance Senior, one of them is Eaton Vance Floating ... they run a few different portfolios with slightly different risk levels.

Benz: So, segueing, Eric, into TIPS, you mentioned that many core bond funds don't hold TIPS. So, if you want that exposure in your portfolio, you may need to layer it on separately. Any favorites in that area?

Jacobson: Sure, and let me just be a little more precise in how I put it. It isn't so much that they don't hold any TIPS, because a lot of them do hold some. But if you really want to have that inflation protection in your overall portfolio, you probably are going to have to do it on your own, because even if your core fund holds, say, 4% or 5% in TIPS, it's not going to ... give you that inflation-protection control you might otherwise be looking for. ...

So, the real easy go-to for me on that is going to be PIMCO Real Return, or for folks who don't have access to the institutional shares or a really low-cost platform to go through, Harbor Real Return is another great choice. They are both run by the same manager at PIMCO, a fellow by the name of Mihir Worah, and not only has he done really well with it, but his predecessor at the fund, John Brynjolfsson, who is not long gone, but he helped build a great record there as well since the day that fund started.

This is a case where it's an interesting hybrid, because it isn't a really pure TIPS fund. It generally has somewhere between 85% and 100% in TIPS. So this is something that goes along with some of the other things we've talked about, where you really have to know what the add-ons are. You don't want to just go willy-nilly with a fund like this if they don't have the capability to manage well with the other 10% to 20% of whatever they are doing.

This is an unusual case, though, where we actually do like a fund like that because they have done a really nice job of moving back and forth and not only investing in TIPS but adding a little extra value with the rest of what's in that portfolio.

Benz: Okay. So how about for the non-dollar-denominated bond exposure? Do you have any favorites that come to mind there?

Jacobson: I would say one of the tricky things here is that it's difficult to discern-- not just to discern--but to discern and choose among the funds based on whether or not they have a lot of non-dollar exposure, or whether they are doing a lot of hedging. For folks who really want to target it and do it for themselves, you might want to just pick a pure unhedged fund--one that as a matter of practice doesn’t hedge anything back to the dollar--and maybe combine with it with a fund that does do a lot of hedging or all hedging. I believe PIMCO and BlackRock both offer something like that. PIMCO Foreign Bond, as an example, comes in both unhedged and hedged versions.

But as far as the single picks that we like, where I would say these are some funds to look at as perhaps a one-stop high-quality non-U.S. choice, you might look at Loomis Sayles. I believe it's Loomis Sayles Global Bond managed by a fellow by the name of David Rolley. And another one that everybody probably has heard of by now but is a favorite fund of ours is Templeton Global Bond, run by Michael Hasenstab.

Benz: That Templeton Fund has hit a rough patch of performance. Any thoughts on what's going on there? It sounds like you still would recommend it.

Jacobson: Yes, we do recommend it. I think the most important thing to understand is that a fund like that has some very long-term "bets" in it. In other words, the themes that he is investing based on are expected to develop over several years. So when you have this sort of intermediate-term volatility, especially with funds that take on currency risk, you have to be ready and willing to stomach some volatility.

This is the case, again, where you have to have a lot of confidence in the manager, and you have to be willing to live out a period as long as a couple of years where you haven’t done quite as well as all the competitors.

Benz: So it sounds like you want to make sure that you know the managers' time horizon and make sure that your own time horizon at least is as long as his is?

Jacobson: Absolutely. I think we find a lot of times people hear a name or see a name in the news, and they think, "Wow! That guy has got a hot hand; I am going to buy that fund," and they become disappointed if they don't perform really well inside of a single year. We really try to discourage people from thinking that way.

Benz: Right. How about emerging-markets bonds? Would you say that people should go out and buy emerging-markets exposure, a dedicated fund, or should they look to their global bond fund and see what kind of market exposure is there first?

Jacobson: Absolutely. Start there first, and see what is in your global bond fund and also take a reality check. Are you happy with that fund and whether you think that that firm has the emerging-markets' depth and capability to be allocating whatever they are allocating to emerging markets.

If you do want to go the other route, though, of course, we have some that we like, and I certainly would encourage people to think about it that way, too. That way you can tailor the exposure. A couple that we've liked for a long time are Fidelity New Markets Income and the PIMCO Emerging Markets Bond.

Benz: Eric, you mentioned multisector [funds], and Loomis Sayles Bond, I know, is there. Any other favorites within that space? Maybe, first tell people what that is? What is a multisector fund?

Jacobson: The interesting thing is that the multisector bond fund, perhaps more so than almost any other category, is really a marketing design. In other words, it's a category that started popping up in the early '90s, in which fund companies said, "Well, we're going to try and build this portfolio that's going to perform well for you almost regardless of what happens, especially with interest rates."

So initially they were fairly plain-vanilla in the sense that they usefully had about a third in U.S. government securities, maybe a third in high-quality foreign bonds, and maybe a third in U.S. corporate high-yield.

Now, they've mixed those up quite a bit, and a lot of them have really gone to a lot more risk than the original designs had. Maybe even if they still have some government bonds in them, they usually have maybe a third in emerging markets, a third in non-U.S., or a third in high-yield, and mixing it up like that. Most of them are a lot more aggressive than they used to be.

Regardless of what they tell you in terms of trying to be a balancing act there, they're almost always big yield chasers, because that's how they compete to sell those kinds of funds--"which has the highest yield?"--which is certainly not the best way to pick them.

But if you find one that you like, that you don't think is there purely for marketing purposes and has actually done a good job, you just want to try to understand how they make those allocation decisions. Are they static? Do they move around? Does the fund company have the capabilities that you want to see there?

Like you mentioned, we've always liked Loomis Sayles Bond. That one is not really a conventional multisector bond fund in the way that I just described. We moved it into that category several years ago because it took on enough risk that it didn't belong in intermediate bond any longer, but it's probably one of the better multisector choices overall.

Another one that really does a lot more of what we expect from a multisector portfolio is Fidelity Strategic Income; that's been popular with some of our analysts as well.

Benz: Last set of categories I'd like to touch on with you, Eric, would be the unconstrained and also the absolute return funds that we've recently seen crop up. Any favorites within those spaces?

Jacobson: As you know, we don't really have any strong picks there, and we're not necessarily pounding the table that people should go out and buy any of these. They haven't received our really high analyst ratings that we're rolling out in the near future.

But the most popular and ... the one that I'm probably keeping the closest eye on is probably PIMCO Unconstrained, which I think, has a good chance of delivering roughly what people are looking for.

We like what we see at JPMorgan Strategic Income Opportunities as well, but it has been a little bit more of a narrower focus in basically showing the profile of a lower-volatility, high-yield kind of fund.

So, there are reasons that people, I think, have been happy with owning both of them, but I don't think either one of them has really proven to be the "knock it out of the park" choice that people were hoping when they started pouring money into them a couple of years ago.

Benz: Okay, Eric. Well, thank you for sharing so many picks, so many ideas. You really covered the waterfront for us, and I hope people had their pens out. Thank you for joining us.

Funds mentioned in this video:

Eaton Vance Income Fund of Boston EVIBX
Fidelity High Income SPHIX
T. Rowe Price High-Yield PRHYX
Hotchkis and Wiley High Yield HWHAX
Metropolitan West High Yield MWHYX
Fidelity Floating Rate FFRYX
Eaton Vance Floating Rate I EIBLX
PIMCO Real Return PRRIX
Harbor Real Return HARRX
PIMCO Foreign Bond (Unhedged) PFIUX
PIMCO Foreign Bond (USD-Hedged) PFORX
Loomis Sayles Global Bond LSGLX
Templeton Global Bond TPINX
Fidelity New Markets Income FNMIX
PIMCO Emerging Markets Bond PEMDX
Loomis Sayles Bond LSBRX
Fidelity Strategic Income FSICX
PIMCO Unconstrained PUBAX
JPMorgan Strategic Income Opportunities JSOAX

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