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By Christine Benz and Eric Jacobson | 08-04-2014 02:00 PM

Why Dumping Your Core Bond Fund Could Cost You

Recent fund flow data suggests that investors may be rethinking past decisions to swap their intermediate-term bond funds with nontraditional or bank-loan alternatives.

Christine Benz: Hi, I'm Christine Benz for

Fund flows can provide an interesting window into investor sentiment. Joining me to discuss some of the choices investors have been making in the realm of bond funds is Eric Jacobson, a senior analyst for active strategies for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: It's great to see you Christine. Thank you.

Benz: It's great to see you in person.

Jacobson: Thanks.

Benz: We're going to look at some of the flows we've seen into various bond fund types, and maybe you can give us a window into what you think is driving investor choices in some of these cases.

Let's start with nontraditional bond. There has been a gusher of new inflows into this category. You've been specializing in this group for a while now. Why do you think investors have been so attracted to this fund type?

Jacobson: Let me start by saying that lot of folks may have heard the term "unconstrained" ...

Benz: ... PIMCO's big fund is called "unconstrained."

Jacobson: That's correct. So that area dominates this nontraditional category. We use the name "nontraditional" because there are few other strategies that are similar, but they don't call themselves "unconstrained," so we wanted to have our category be broader, but it's really a lot of unconstrained funds.

That's a big part of it, because these funds have been marketed as not only go-anywhere, but go-anywhere and give your manager lots of latitude, not just in terms of sectors and so forth, but also in terms of managing interest rate sensitivity.

As we've talked about for the last several years, a number of these have been relatively short, but with the promise that they can go longer if necessary, and they can go negative if necessary. It's just been a huge success for the industry, and it's worked wonderfully well from a sales perspective, because up until recently, people have been pulling money out of their core funds that have rate sensitivity, and trying to escape to something like this.

Benz: The interesting thing is, when you look at performance, some of those core fund types that investors had been pulling their money from have actually outperformed some of the nontraditional bond funds, in part because of their greater rate sensitivity.

Jacobson: That's exactly right. This is something that I think people really need to try and understand better, because it says something about both categories. I have been harping on this: The nontraditional category, as much as the focus and discussion is all about rate sensitivity, and the fact that they're going to be safer because they're either shorter or very tactical, most of them have tried to make up for the low-return possibilities with more credit risk. That has a lot of impact on how they've performed.

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