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Year of Living Dangerously

Bond investors were rewarded for their risk-taking in 2012. Will they face a reckoning in 2013?

Miriam Sjoblom, 04/08/2013

The flow numbers are in for early 2013, and investors’ enthusiasm for bond funds is showing no sign of abating. Between open-end funds and exchange-traded funds, taxable-bond fund categories gathered an estimated $32 billion during the month of January. That’s a large monthly intake, even compared with the near constant deluge flowing into bond funds over the previous 36 months. During 2012, credit-sensitive bond funds grew in popularity as yield-starved investors embraced the risk-for-income trade-off. Net inflows for the year into both high-yield ($33 billion) and emerging-markets bond funds ($28 billion) broke records. So far in 2013, investors haven’t lost their taste for the more staid intermediate-term bond category, but appetite for credit-sensitive sectors also remains strong.

Risk Pays Off
The reach for yield has proved rewarding so far. In 2012, the bond market spoils generally went to managers who were willing to take risks, particularly credit and nondollar risk. High-yield and emerging-markets bond benchmarks returned between 15% and 19% last year, for example. Nonagency residential mortgages, for which there isn’t a reliable index, were reportedly up even more than that. Within those sectors, the riskiest bonds have outperformed. In emerging markets, that means the likes of Venezuela and smaller frontier markets, and in high yield, that means CCCs and cyclical industries such as homebuilders. Meanwhile, a host of currencies in Asia, Latin America, and Eastern Europe, where investors can find relatively high real yields (compared with negative real yields in some developed markets), appreciated against the greenback. The Polish zloty had the year’s best run, appreciating 11% against the dollar, while the Mexican peso (up 7.5%) was a more popular trade among bond managers.

None of these areas is represented in the widely followed Barclays U.S. Aggregate Bond Index, which was up a relatively modest 4% on 2012 and has even lost some ground this year as U.S. Treasury yields have inched higher. Many funds in the intermediate-term bond category have increasingly ventured beyond their U.S. government- heavy benchmark, so it’s not surprising that more than 80% of the category beat the index in 2012. A few well-known managers rocketed to the top in this climate, in some cases finding redemption for a trying 2011. Bill Gross shook off his infamous 2011 slump–an event that prompted him to issue a formal mea culpa to shareholders after last year’s third quarter–as bets on financial corporates, mortgages, and emerging markets helped PIMCO Total Return PTTRX generate a 10% return for the year, outpacing close to 90% of its peers. What has worked for funds in 2012 didn’t work in 2011, though, when more than 80% of the category lagged the Barclays index.

Will 2013 Be Different?
Can bond-fund investors expect a repeat of 2012’s robust rewards for risk-taking? That doesn’t look likely. At the end of 2012, investors were concerned about an escalating eurozone sovereign debt crisis, worries that were reflected in the relatively wide yield spreads offered by credit-sensitive sectors compared with government bonds. As policy actions calmed those fears and low yields on high-quality bonds pushed investors to take more risk, spreads across many sectors have shrunk back to their historic norms. Absolute yields have also dropped over the course of the year, to a surprising extent in some cases. Conventional wisdom has held that high-yield investors generally lose their appetite for junk bonds once the sector’s average yield sinks below 7%, for example, but it blew through that level last summer and now hovers below 6%. Loomis Sayles’ Dan Fuss recently told Bloomberg News that the high-yield market looks more expensive than at any point in his 55-year career, calling valuations “ridiculous,” yet his flagship Loomis Sayles Bond LSBRX fund still devotes nearly 20% of assets to high-yield credit.

In a yield-starved market where nothing looks cheap, it’s not out of the question that the push to take more risk will continue to prove relatively rewarding in 2013, although not at the same magnitude. Still, many portfolio managers note that risks are mounting, and they’ve taken steps to dial down the risk in their portfolios to varying degrees. Moreover, with absolute yields across sectors touching all-time lows, there’s less of an income cushion to protect against rising interest rates than ever before. Investors are also likely grabbing for a sliver of extra yield wherever they can get it, and sacrificing safety in the process.

It also seems that investors are letting their appetite for yield drive their decision-making in areas typically prized for safety. For example, more than a quarter of the net $37 billion taken into short-term bond funds in 2012 went to one fund, Lord Abbett Short Duration Income LALDX, which has the second highest 12-month yield in the category, more than twice the group median at 4%. Municipal-bond funds are another area where investors seem to be making a mad grab for yield, stashing unprecedented sums in high-yield muni funds and favoring funds with the fattest payouts, but also the riskiest portfolios.

T. Rowe Price’s fixed-income director, Mike Gitlin, also recently noted that the nonstop flows into bond funds since 2008’s financial crisis have coincided with a retreat from the broker/dealer community, a factor that could hurt market liquidity when investor sentiment reverses. Overall, there’s a mismatch between the near-universal note of caution we’re hearing from bond managers and investors’ continued enthusiasm for bond funds. That’s reason enough for investors to think twice before loading up on bond market risk in general, including squeezing that extra bit of yield out of a credit-focused fund.

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Miriam Sjoblom is an associate director of fund analysis at Morningstar.
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