Thu, 12 Jan 2012
Morningstar's Eric Jacobson comments on 2011's long-term Treasury rally, fund managers' current perspectives on government debt, PIMCO Total Return's current positioning, remaining opportunities in munis, and top considerations for fixed-income investors today.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Here to reflect on the past year in bonds and bond funds as well as talk about what could lie ahead for bonds is Eric Jacobson; he is director of fixed-income research for Morningstar.
Eric, thank you for so much for being here.
Eric Jacobson: Glad to be with you, Christine.
Benz: So, Eric there was a lot of trepidation coming into 2011 among bond-fund investors. People were concerned that interest rates could go up and a lot of different things could go wrong for the asset class. But it actually turned about to be a pretty good year for bonds. Let's start by talking about what the bright were spots last year.
Jacobson: Sure. Well, anyone who had long Treasury exposure, whether we're talking about individual funds or the funds themselves having that exposure, did really, really well. The long-term government category, as one might expect, just blew off the roof with plus-30% returns.
Hopefully, not too many people are chasing those though because it's really hard to repeat that kind of thing. But like I said, anybody who had even market-level exposure to the Treasury market and anyone who's a little bit long in U.S. Treasuries did very well. Treasury Inflation-Protected Securities did really, really well last year as a result of that, even though inflation was pretty muted, because they tend to be very sensitive to what we call compression among the real yields. And so falling interest rates helped TIPS a lot also.
Benz: So, if you were in line with the Barclays Aggregate Bond Index in terms of your government-bond exposure that was great, but the fact is most active bond managers were not. They were light on Treasuries. What are you seeing among active bond-fund managers now? Are they kind of playing catch-up given that many underperformed the index in 2011?
Jacobson: It's really interesting because I think the tendency on the part of a lot of managers is probably to be careful because nobody really wants to get what you call whipsawed by moving too aggressively back into rates now that they've done so well. On the other hand, nobody really wants to get caught in the same situation happening over again.
It's unlikely to be a repeat, but if we have a situation where Europe continues to deteriorate and our economy does not do as well as people are hoping right now with the new jobs number for example, it is possible that Treasuries could continue to rally some. So what we've seen is that, even though the average manager was short of the index, say back in March or the middle of 2011, the data that we have so far at the end of this year shows that they're roughly about even with the index on average across the category of intermediate-term bond managers, for example, at this point in the cycle. So, I think roughly what that's telling us is that they've sort of tried to move back to neutral whereas most of them were playing a lot more defensive before, even though, in some ways it might seem like a good time to be defensive.
Benz: Right, it wouldn't seem that many fund managers would be able to argue that Treasuries represent a really good value at this point in time given how absolutely low yields are.
Jacobson: That's right. I think frankly what a lot of them are is just afraid. They don't want to have happen to them in 2012 what seems to have happened to Bill Gross in 2011, which is that he really removed a lot of Treasury-rate sensitivity from PIMCO Total Return, and in fact, he was taking on rate risk in other places. Because of that, he was shorting Treasuries in the U.S. to try to remove some of that rate risk, but in effect it came out looking like a pretty big short on Treasuries. It didn't work out well.
PIMCO Total Return ended the year poorly, and a lot of people have been talking about it. Nobody wants to have that lens focused on them, if the same thing happens or even if something similar happens in 2012, let's say.
Benz: Let's just spend a second talking about Gross, Eric. His big Total Return funds are so widely held, How is he positioning in relation to Treasuries right now? Is he still sticking with that fairly negative stance on Treasuries or has he too backed off of that somewhat?
Jacobson: Yeah, I don't think he's quite neutral with the overall Treasury exposure, but he has kicked it back up quite a bit from where it was. And he's taken on a lot more rate exposure than he had earlier in the year. As some people know, he wrote a column earlier in the year called "Mea Culpa," essentially agreeing that he probably shouldn't have been as extreme in the portfolio as he was, and he has essentially reversed that bet. Things are now looking a lot more aggressive in the portfolio relative to where they were.
Benz: In terms of interest-rate sensitivity?
Jacobson: Exactly. That's right, but he also has a considerable amount of emerging-markets, high-yield, and non-U.S. exposure in that portfolio, too--a lot more than he used to carry prior to the last couple of years. And I think that's important for people to understand. He seems to have managed it reasonably well, but when you look at the fund's returns for 2011, that's kind of what you see. Emerging markets did not do that well, foreign bonds did not do that well, and he didn't get that big tick from the Treasuries. So, it wound up hurting him for 2011.
Benz: Right, Eric I want to talk about another bright spot, and I think this was unexpected for many bond investors in 2011, was municipal bonds. They were very beaten-down in the early part of the year, and there was a lot of fear there. But they really were kind of the comeback kids of 2011. What went on in the muni market?
Jacobson: Well there were really two big things there. One was the general rising-rates sell-off that occurred toward the end of 2010 and into the beginning 2011, and as much as it hurt regular bonds, such as corporates, Treasuries, and what have you, it really caused a lot of pain in the muni market in part because of the sentiment in the muni market was so poor.
As I'm sure, a lot of people recall, analyst Meredith Whitney came out with a very public statement, saying, that she expected billions and billions in defaults in the municipal market. That spooked a lot of people, and it caused a lot of outflows. One can assume that it triggered a lot of the outflows that occurred. Instead, municipal finances held up reasonably well coming into 2011. There wasn't as nearly as much reason for panic as people had thought. Even though munis still looked relatively cheap compared with Treasuries in particular, they bounced back from those lows pretty nicely along with the rest of other really very high-quality assets like Treasuries, and they turned in very, very solid returns for 2011.
Benz: So, if I'm looking back on my portfolio and I've had muni bonds in my portfolio. After such a good run, would it seem like time to lighten up? Or do you think potentially there is still a little bit of value left there?
Jacobson: Well, I think a lot depends on where you are with your interest-rate positioning. If you have a lot of interest-rate risk in your muni portfolio, you want to step back and ask yourself if you're comfortable with that. It's a very, very difficult time to make that call right now because we're right on the edge of not really knowing if we're out of the recession and in a recovery, and do we know what's going to happen in Europe? If Europe seems to slide into worse trouble, that could continue to put pressure on what we'd call risk assets, such as high yield and so forth. And it could continue to grind Treasury yields lower, and if that happens and as long as municipalities remain pretty healthy, you are going to continue to have probably pretty good returns in munis.
On the other hand, do you want to make that bet with the possibility that we could be at the beginning and of a reasonably strong recovery. If we are, that probably signals a rise in yields, and municipals will probably be tracked somewhat well with Treasuries in terms of yields going up and prices going down. So, I wouldn't be too drastic with many changes, but if you're taking on lots of interest-rate risk in your muni portfolio, you might want to review that. Otherwise munis actually look still relatively cheap compared with Treasuries even after the run that they have had in 2011. Part of that is because the liquidity hasn't been there. The dealers haven't jumped back in the market, and a lot of demand in the market went for other things. So, it still is not a bad time overall, notwithstanding the interest-rate question, it's not a bad time for munis.
Benz: Now, Eric I want to shift gears. There were a few pockets of the bond market that were disappointing in 2011. One was this category we created this past year, called nontraditional bond. It includes a lot of the unconstrained funds or things that don't readily fit within the framework of categories we had before. Let's talk about what went on with some of those funds. I know that there was a lot of enthusiasm for those unconstrained funds certainly in the first half of the year, but they had a pretty disappointing performance. What were the main drivers for that category?
Jacobson: Well, as you know, that's where a lot of the fear money went, and even among these firms that were relatively weak on interest-rate risk coming into 2011 and didn't perform as well as the indexes, there were shareholders in those funds who didn't want to be there or even they wanted to get rid of their interest-rate risk. They clamored for another option, and that's why a lot of firms either rolled out or continued to press with marketing these nontraditional strategies that are usually included in some sort of "absolute return" moniker or "unconstrained."
But really what a lot of them just did in 2011 was they took off as much interest-rate risk as possible, and they put on other kinds of risks. It was very often either high-yield or emerging-markets kinds of risk, and they took the risk elsewhere, other than in interest rates. That turned out to be, I won't say a formula for disaster because it wasn't necessarily so, but it certainly was not one for success because as you know the third quarter of 2011 was relatively poor for high yield. It was poor for pretty much all so-called risk assets, anything that has a liquidity bend to it or wasn't a Treasury. And for the year, those kinds of things did not float in that well. Emerging markets didn't do that well; high yield didn't do that well. And if you didn't have even a market waiting in interest-rate exposure and certainly didn't have a long exposure to interest rates, then you didn't get that balance. You didn't get the kick from the rates as others things did poorly. That was the story really for a lot of 'nontraditional bond funds,' and the average fund lost more than 1% for 2011.
Benz: So, credit sensitivity generally, which shows up in these funds, was not well rewarded last year?
Jacobson: That's absolutely right. The indexes don't necessarily make it look that bad because the high-yield indexes eked out a couple of percentage points in gains. But depending on how the funds played it, they didn't do qui-e as well. The high yield index was off something like 6% in the third quarter, and that was pretty painful for a lot of funds.
Benz: Right. So, Eric, I just want to spend a few moments here looking forward. It's sort of ironic because I think a lot of investors think of their bond portfolios as being their ballast, being the safe, sleep-at-night portion of their portfolios. But fixed income has really been quite vexing for so many investors, and so I guess I would like to get your best counsel for folks who have sizeable fixed-income portfolios, how they should think about managing that portion of their portfolios as they think about 2012 and the years ahead.
Jacobson: Well, it's going to sound like a boring broken record I think, but I am in big favor of having that kind of diversification, focusing on core funds, doing a little bit about the margins if you want to, but try not to be too extreme with the decisions that you make because we keep running into years like this, 2011. If you had moved a huge chunk of your portfolio in the nontraditional bonds, it really probably hurt you in 2011. So, even though, for example, the average intermediate-term bond fund didn't do very well in 2011 relative to the index, the average fund was up over 5.8%, I believe, and still managed to provide some balance for a stock-heavy portfolio that probably didn't do that well on the other side. Like I said, if you had gone into nontraditional bonds with too much of that money, you really removed some of that balance out of your portfolio.
The tricky part is, we're not in a trend period right now where it's very easy and obvious to say where we are headed. We're not in the middle of the rising-rates period, and we're not necessarily going to be in the middle of a falling-rates period either because as you know, we just had these positive employment numbers. There is a lot of talk about some resurgence in the economy, but at the same time we've got the risks that are going on in Europe. There is still an expectation I think from a lot of people in the industry, but there are other shoes to fall in Europe. So, it's very hard to be decisive and say, you really ought to loom one way or the other. I would stick with the old tried-and-true rules of staying diversified. Make your decisions about how much you want in stocks and bonds based on your overall risk profile, whatever it is your goals are that you are saving for, the kind of personal-finance decisions that you work on so much, Christine. I think that's the way to steer it.
Benz: One last question, Eric, if you had to name a few sort of core funds that you can think navigate well in an uncertain environment where you have some confidence in the management teams, can you just quickly give us a short list?
Jacobson: Sure. Well, maybe this is a little bit contrarian, but I still think that Bill Gross is a great manager. I still think PIMCO Total Return is a great option. 2011 was certainly a bumpy year for him. I don't think we are probably going to see anything like that again in the near future. You can certainly get through PIMCO Total Return in certain 401(k) programs for a lot of people. Otherwise Harbor Bond or Managers PIMCO Bond are other good choices. We have long been fans of Metropolitan West Total Return; that's a really good one that has a lot of diverse sector exposure in it and things like that. So, those are some of my long-time favorites that I would steer people toward, but they can also, as you know, look at our list of funds on our website and examine what we think about them.
Benz: The Gold and Silver rated intermediate-term bond funds. Well, Eric, thank you so much for being here today. I really appreciate it, and I know our users always love to hear from you. So, thanks for taking the time?
Jacobson: Glad to be with you, Christine. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.