Thu, 5 Sep 2013
Senior fund analyst Eric Jacobson walks us through how some of Morningstar's top-rated intermediate-term bond funds fared during the early summer sell-off.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com. The recent interest-rate shudder provided a good stress test for bond funds. Joining me to provide a look at how Morningstar's top-rated intermediate-term bond funds did during the early summer period is Eric Jacobson. He is a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Good to be here, Christine. Thanks.
Benz: Eric, let's do a little stage setting. The bond market sold off in May and June, and that was only because Ben Bernanke indicated that the Fed may start tapering this bond-buying program that it's been on, but the Fed didn't actually take action. So why do bond prices react even when the Fed hasn't actually taken action yet?
Jacobson: Well, it's just like you've seen sometimes in the equity markets, as they say, things get priced in early sometimes. So in this case, it's all about fear. Everybody is worried that the biggest buyer in the bond market is going to pull back and not be there, and that just sent shock waves through the marketplace and triggered all that worry in a sell-off and brought yields up to a place where they hadn't been for quite a while.
Benz: Right, for couple of years even. You looked at our top-rated, our Gold- and Silver-rated intermediate-term bond funds, at how they performed during this period, and you really found quite a cross-section of different results. What was the general range when you looked at results for our highest-conviction funds during this particular period?
Jacobson: Right, and again, it's important to mention these are the highest-rated funds in the intermediate-bond categories, it's not the category itself. But one of the best performers was Dodge & Cox Income
Benz: I want to back up and discuss what Dodge & Cox got right during that period, but first let's talk about what's going on at that PIMCO fund. Obviously, we're looking at a very short time frame here. In fact, the manager [Mark Kiesel] was our [Fixed-Income] Fund Manager of the Year in 2012. But what was working against it in this interest-rate shock that we saw?
Jacobson: One thing I think is that the fund uses a longer benchmark than most funds in the category. It uses a credit index and doesn't have the mortgages that are in the Barclays U.S. Aggregate, and those mortgages tend to have shorter, lower durations. So this fund even at neutral to its benchmark is fairly long in its maturity and its duration. That's one factor. It also had some sector issues. It had an allocation to lower-rated natural gas pipelines. The fund also had an overweighting to metals and mining, and some of these more sector-specific issues were a problem in the second quarter as well.
Benz: Obviously, commodities have had a tough go recently. Let's take a look at the big flagship over at PIMCO, Total Return
Jacobson: One of the problems was that Bill Gross, the manager, came into the period a little bit long, and in particular, the fund also had a reasonable allocation to TIPS. And TIPS sold off pretty badly during the interest-rate shock, and emerging-markets bonds have performed very badly as well. So even though they're not enormously weighted in the portfolio, they're an important part of the portfolio, and they did play a role in pulling the fund back a little bit from its peers, and it's actually doing pretty poorly for the year to date still.
Benz: I noticed in your recent analyst report, though, you still have a lot of conviction in the fund. In fact, it's one of our favorite ideas in the intermediate-term bond group.
Jacobson: Yes, I don't think there's anything about this period that indicates a major structural problem with PIMCO, or a problem with the process, etc. I think, inevitably, any manager is going to go through periods like this, where it happens to be worse than it had been a long time. But very often Gross has been early and still right. I'm not saying that's automatically going to be the case here, but I still think he is one of the best managers in the business.
Benz: Let's take a look at some of the funds that managed to really shine during this period. You mentioned Dodge & Cox Income, what worked in its favor during this quite short period?
Jacobson: Dodge & Cox for a long time has had a short duration relative to other funds in the category, and they've been very concerned and cautious about the interest-rate markets. So that's been a huge help. They also had a little bit more exposure to credit-sensitive bonds that did perform better than the worst-hit--the municipals, the long-duration Treasuries, and so forth.
Benz: Dodge & Cox got caught leaning the right way in this particular case. How about Janus Flexible Bond
Jacobson: Similar story. Comparatively short duration relative to the benchmark and some of the peers and also has a lot of mid-quality corporate bonds. That sector performed relatively well during that stretch.
Benz: I noticed another fund that has long been on our favorites list, MetWest Total Return Bond
Jacobson: Yes, and again, the short-duration, shorter-duration story is a big part of it. As part of that, they had a lot of mortgages, mortgages tended to hold up a little better during this shock, partly because of the way they're structured and the fact that they have shorter duration. The fund was just very, very light in Treasuries as well.
Benz: Another fund that may not be as familiar to our viewers, Scout Core Plus Bond Fund
Jacobson: It's subadvised by a manager that we really like called Reams [Asset Management], and they've been very sort of off the radar for a long time because they've always been a manager of institutional portfolios. In terms of what they got right, they had a very short duration of only two years, and so that was a big factor in [why] they were able to really beat up everybody else, if you will, with a modest loss.
Benz: I guess one thing I would like to hear from you, Eric, is what's your general counsel for investors right now? They are looking at this period, and I'm talking to a lot of investors who are very scared about what lies ahead for bonds and they're really eager to purge any long-duration bonds from their portfolio. They're getting quite active in terms of managing their portfolios. What's your counsel to investors at this point in time?
Jacobson: My biggest concern really is that a lot of investors are pulling out of the traditional bond funds that they've owned. They're going into either what we call nontraditional bond funds or a lot into high-yield and bank loans, for example. There are some concerns that we're getting to the point where valuations in those most credit-sensitive sectors are starting to get a little frothy. I don't know necessarily that we're anywhere near any kind of crash or anything like that. There isn't any fundamental reason on the horizon, other than the frothiness that really spooks most people. But you start to see these things early on in credit cycles. It may take a while to develop, but at some point if investors continue to flee the most rate-sensitive parts of the market, they will get cheaper and the high-yield, more credit-sensitive stuff will get more expensive.
The other issue, as I mentioned, is this nontraditional bond space. They've done probably better than the core funds during the sell-off, but they didn't completely protect investors from all losses. I think that's an important thing for people to realize. You might get some cushion from these nontraditional bond funds, given that a lot of them are relatively light in interest-rate sensitivity and a little heavier in other kinds of risks, sometimes credit risk, but they're not a silver bullet and they're not a panacea and they're not going automatically protect you.
My biggest piece of advice would be: Step back, look again at what your asset allocation is, why it is the way it is, and try to be faithful to what your plan is. If you're investing for the very long term, and yet you have a particular reason that you've got a lot of bonds in your portfolio, think about why they're there and whether or not they're going to be as risky as equities, which generally they won't be.
Benz: Is it your concern that some of the categories that investors have been adding to most aggressively will, in fact, be more equity sensitive, and so the whole portfolio is going to be more responsive to the equity market and certainly the economy?
Jacobson: That's absolutely right, especially when you get those valuations squeezed. The tighter they get, the more sensitive they get to market shocks. And because they tend to be these kinds of things like high-yield [that] are particularly low in the capital structure, a lot closer to equity than to high-quality bonds, and you do wind up having those higher correlations in your portfolio, which you've got to be careful about.
Benz: OK, Eric. Always great advice, always great to hear from you. Thanks for being here.
Jacobson: Glad to do it, Christine. Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.