Mon, 26 Mar 2012
Core bond funds have cut their interest-rate sensitivity relative to their benchmark, and Morningstar's Eric Jacobson says the dramatic changes in correlations have skewed common metrics, such as beta.
Christine Benz: Hi. I'm Christine Benz for Morningstar. Although many core bond funds use the Barclays Aggregate Bond Index as their benchmark, in recent years more and more core bond funds look nothing like the index. Joining me to discuss that phenomenon is Eric Jacobson. He is director of fixed-income research for Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: I'm glad to be with you, Christine.
Benz: Eric, you recently wrote a commentary--it was quite thought-provoking--where you discussed how core bond funds have really gotten pretty far away from the Barclays Aggregate Bond Index in recent years. Can you discuss generally what you found?
Jacobson: Yes. We've noticed this in sort of a creeping fashion for quite a long time, ever since the financial crisis. What we've seen, though, is that a lot of managers have owned fewer Treasuries, which isn't that much of a surprise, but we've also seen overall that has meant a lot less interest-rate sensitivity at the fund level. And we've seen managers either building up areas of the market that are lightly represented in that core index--the Barclays U.S. Aggregate that we use as the lodestar, if you will--or going into areas outside the index entirely. In some cases, they're building up relatively large weightings there.
So when we took that as our base information because we know it's true just from looking at the funds, and then went back and looked at some correlations and what we call R-squared--the other statistic that bakes all that together--we found that whereas in previous periods prior to the crisis, you used to have a very, very high correlation of funds to the index, in some cases, on a scale of 1 to 100 where 100 is the highest R-squared, if you will, you'd have funds frequently in between 95 to 100 most of the time. You're finding now that that's just not the case any longer.
Benz: So, these are actively managed funds, too, with very high R-squareds, but that has changed?
Jacobson: That's correct. They've always been actively managed funds, but because they've been closely aligned with the index, and very tightly bound in many cases in terms of interest-rate sensitivity, their correlations tend to run very, very high.
Benz: So, you mentioned, Eric, it's probably not surprising that active fund managers would be downplaying government bonds, but just walk through what is the thought process in driving that change?
Jacobson: There are two things going on. One is that the index itself has become much more government-centric with explosion, if you will, in Treasury issuance that many people are probably aware of just by virtue of the fact that we've got so much government borrowing going on. In addition, most of the mortgage market is now underneath the auspices of Ginnie Mae, Fannie Mae, and Freddie Mac, and even though Fannie and Freddie aren't technically government entities, they are essentially under the umbrella of the government. So even though mortgages do act a little bit differently than Treasuries still, you've got this huge percentage of the index that's very, very highly tied to the government. So you've had managers say, "Even though this is our index [Barclays], and this is the one we've been using all along, these are unusual times. We shouldn't necessarily feel compelled to be right on top of it, either in terms of interest-rate sensitivity, which is very highly affected by where the issuance is in the government market, or by the sector allocations that are in there, which are being distorted, of course, by what's been going on, as well."
Benz: You mentioned that you have observed several funds where there was once a very high correlation in terms of performance and maybe portfolio positioning relative to the index and that has drifted downward, can you provide any examples of funds that have demonstrated this trend?
Jacobson: Yes. What's really remarkable is if you look at the list of say the top 15 or 20 funds just in terms of size, it is a pretty dramatic change, almost all the way down the list, with the exception of those that are index funds like Vanguard Total Bond Market, which is about the second-largest fund there is. But other than that, you're taking a look at PIMCO Total Return, which has an R-squared down in the high 30s now. At one point prior to the crisis, the fund's R-squared generally, like I said, had been up in the high 90s. We're talking about American Funds Bond Fund of America; we're talking about Dodge & Cox Income. Some of these are more distinct than others in how far away from the index they've gone.
In some cases, it's not so much that they've bought a lot of things that are way outside the index and are taking on crazy risks. But when you combine the lighter level of interest-rate sensitivity and a little bit more intrepid attitude in terms of going out in maybe a dash of high yield, a dash of emerging markets, or even frankly higher-quality non-U.S. ideas, like Canada, that is enough to tweak these numbers out. And if you looked down the list, you'll see that most of the top 20 have much lower R-squareds today than they did five years ago.
Benz: This tendency of funds to look different from the index that has the opportunity for them to perform better, but also in 2011 we really saw that it worked against a lot of funds, diverging from the index.
Jacobson: That's absolutely right. If there was one lesson from 2011, it is that the intractable rule--that it's hard to predict the direction of interest rates--is still a pretty intractable rule. Very few managers really were sorry for it, with the exception maybe of PIMCO's Bill Gross, who did so poorly that he felt compelled essentially to apologize for it. For the most part, managers have said, "Yields are still very low. It wasn't a bad decision to keep our interest-rate sensitivity low, and we're still going to do it."
I think, in a lot of cases, they don't want to get burned by switching their attitude at the wrong time. And hopefully, as you can see, that's what's happening right now, as we've had yields spike up in the last few weeks. But a really, really hard call to make is the direction of interest rates.
Benz: So, if I'm an individual investor and I'm trying to keep track of this issue, and maybe conducting due diligence on my portfolio, should I focus on R-squared versus the Barclays Aggregate or do you have any other tips you can share to see how closely the core bond exposure in your portfolio is tracking the index?
Jacobson: My first piece of advice is don't depend on any single metric to make any kind of decisions because there are lots of reasons that any of these numbers can get skewed. Right now, now that R-squareds are relatively low, that means that lot of the other statistics aren't that useful, so for example beta isn't all that meaningful now when you have a low R-squared for a fund, and it also means that alpha isn't all that useful either. Beta is loosely correlated in many people's minds with just general level of volatility. Normally that means how much volatility do you have relative to the market? Alpha generally means, how much outperformance is there? You can't really rely on those metrics if the R-Squared isn't very high. And so I would say it's a nice first cut. It's a thing to look at and say, "Something is different here, but again it's different across the board for almost all funds. So don't panic."
But take a look under the hood, and see what you think might be causing it. Is it because the fund has a much lower duration, and are you comfortable with that? Is it because the fund has a lot more high-yield, non-dollar, emerging-markets, or municipals exposure than you would expect? That's likely to be at least part of the story, and you want to make sure you are comfortable with the risk profile. But in many cases that's what you're going to find across the board, because managers just don't want to take that Treasury risk.
Benz: Right. Last question for you, Eric, it seems like one tendency that you've noted among these funds is in addition to decreasing interest-rate sensitivity, there is also a shift generally toward downplaying government bonds. I guess the question is, in a true, 2008-style market shock, is there a risk that some of these core bond funds that are moving away from the Treasury market will be less defensive?
Jacobson: Your question is perfectly worded because it differentiates the kind of market shock you're talking about. If we see another 2008-style shock, where we had essentially risk assets selling off the most and the worst, then I think you're going to find that funds are going to underperform the index. It would likely be even worse, in some cases for the bond market anyway, than it was in 2008 because you've got even more diversions from the index than you had at that time. But the fact of the matter is that the entire system is very different than it was then. We've deleveraged quite a bit, if you will. There is a lot less debt out there to "unwind and cause that kind of shock." The real question now of course is probably more likely what's going to happen with interest rates? At least where we stand right now, whether you think that they're going to go up or not, it doesn't look like funds are too badly positioned for even a drifting-up of rates based on how little interest-rate sensitivity they have relative to the index.
Benz: Well, thank you, Eric, for sharing your insights. This is some great research and I think very useful for investors, who are gauging their fixed income portfolios. Thanks for sharing it with us.
Jacobson: Well, thanks for having me, Christine.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.