Sat, 28 Dec 2013
Although many fixed-income fund categories had a rocky 2013, investors should heed the dangers of swapping their bonds for cash or stocks, says Morningstar's Eric Jacobson.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. As equities soared in 2013, bonds logged a forgettable year. Joining me to recap the year in bond funds is Eric Jacobson. He's a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: It's always great to be with you Christine, thank you.
Benz: Eric, generally speaking, it was a year to forget for fixed-income funds, but there were a couple of pockets of strength. Bank-loan funds and high-yield funds led everybody else by a long distance. Let's talk about the key drivers for those categories.
Jacobson: I think that there are two sides of the coin. One is that both categories performed reasonably well over the summer, when the bond market sold off quite a bit mostly driven by rising yields on the high-quality bonds, Treasury bonds, what have you. And because of the fact that bank-loan funds have very little interest-rate sensitivity, and high-yield funds have a little bit of more, but still not very much, and [the fact that there was] a lot of income coming off of [these types of funds], they were reasonably well-insulated from what happened.
The other side of the coin is that the economy--even though there are still some questions as to whether it's really reached what you might think of as escape velocity from where it's been--has been reasonably healthy and default rates have been relatively low. As people have probably heard, there's lot of cash on corporate balance sheets, et cetera. And so that's been a good backdrop for real credit-sensitive instruments.
Benz: I have a related question for you, Eric. You mentioned that the fundamentals are looking pretty good for these two groups. But do you think that there is an element of yield-chasing that's going on here, as well, and that is pushing up demand for the bonds?
Jacobson: There's no question about that, certainly. I think, another way to put it is that, some of that thinking about where the economy stands, you could even interpret as a little bit of rationalization because people are saying, "Well, the yields aren't very high, but I'm still going to buy it because the economy is doing OK and the fundamentals look good."
I do think that there is some thought among folks in the investment universe that things became a little more fairly valued when yields spiked up over the summer time. But in general, I think there's a broader sense that things are quite dearly priced when it comes to some of these sectors that are traditionally yield generators.
Benz: At the other end of the spectrum, anything that was very interest-rate-sensitive had a very weak year. Let's talk about the drivers there.
Jacobson: That again was very much driven by what happened over the summer. As you know when the Fed signaled some talk about when it might start tapering the quantitative easing program, the market reacted very strongly. We saw a relatively large spike in interest rates. The 10-year Treasury went from about 1.63% in early May to up to about almost 3% by early September. That really had a very strong effect on returns for the overall year, especially for the more rate-sensitive types of the market.
Benz: The long-duration government bond sector really was probably the hardest-hit. One category that investors might have been a little bit surprised about the performance weakness of was the Treasury Inflation-Protected Securities category. Let's talk about that group and why losses were so great during 2013.
Jacobson: There were a few things going on. Some of them were just very basic and fundamental to it, which is the fact that the TIPS universe tends to skew toward the longer maturities. The interest-rate sensitivity of TIPS to conventional Treasuries tends to be very high especially at times like this when yields are very, very low and they tend to correlate very highly with each other.
Another thing that actually happened that got a lot of play in the investment community, but perhaps not as much in the mainstream press, is that there were certain kinds of investors, often referred to as risk-parity investors, for whom their models indicated that that was a time to get out of TIPS in particular. And depending on who you talk to the story is that they dumped a lot of bonds in the market. TIPS also have a reputation in the investment community for being relatively illiquid compared with other types of fixed-income instruments. So that was a little bit of a perfect storm for TIPS.
Benz: A bad convergence. I want to talk about municipal bonds, as well, because muni returns were actually worse than taxable-bond returns. Let's talk about the main drivers of that level of underperformance.
Jacobson: There, too, you've got a few things going on. One of which is just that the muni universe also tends to skew a little bit long. So you have more long-maturity bonds. You've got, generally speaking, smaller coupons, and that makes for more interest-rate sensitivity.
At the same time you had a notable set of redemptions from the municipal universe. Given the fact that a lot of municipals are held in funds and by individual investors rather than by corporations and institutions, a lot of that selling had a pretty notable effect. I would also say some of that selling and some of that negative thinking in the market was exacerbated by some of the headlines that occurred over the summer, especially with Detroit defaulting, Puerto Rico having some fiscal problems, and so forth. It just wasn't a very good time for municipals in general.
Benz: Eric, we've seen an explosion in assets in a couple of categories you mentioned. Bank loans have been seeing big flows. Another category that has been a big beneficiary of new money is this nontraditional bond category. How did that group do in 2013, which is arguably the category's first real stress test?
Jacobson: It's all sort of relative. The median fund in the category of funds that were around over the summer time lost roughly 2%, and compared with more traditional conventional bond funds, that was a pretty reasonable performance. The figures I'm giving are from May 2 through Sept. 13, which is roughly along the period that we're talking about there.
The Barclays U.S. Aggregate Index was down about 4.3% during that period. The average intermediate-term bond fund was down just a little more at about 4.4%. So on average these funds did hold up better during the rate spike, and that's kind of what we would have expected given that so many of them have really focused their marketing and their operational attention on keeping interest-rate sensitivity relatively low at this period, even though a lot of them have a lot more flexibility to take it longer.
Benz: I think the big question for anyone looking at fixed-income investments right now is what does the Fed's plan for tapering mean for fixed-income investments? I know investors have been very inclined to keep their interest-rate sensitivity short. Is that a prudent strategy? What kind of tips would you give to bond investors at this point in time?
Jacobson: It's tricky because I think that anytime the conventional wisdom starts to really build up on one side of the argument, you need to step back and ask yourself if that makes a lot of sense. And the fact is that people have become so focused on the fear of rising yields that one sort of has to wonder whether it's little bit more panic than is necessary. I think that it is somewhat hopefully inevitable because it means that the economy will be doing well. But inevitably, as long as that happens, bond yields will go up at some point. The real question is how long will that take? What will you give up while you are waiting? Will it occur over a long enough period of time that you will actually do OK with regular bond funds and market-average interest-rate sensitivity?
Those are really hard questions to understand and to answer, and I think that's part of the reason that people are so concerned and anxious. On the other hand, what we saw [earlier in December] that the Fed finally did announce that it's going to start it's tapering with a relatively modest amount of pulling back on purchases. The market didn't react that strongly. We only saw the 10-year Treasury sell off a very small amount. And I think one could argue that based on where yields are today the market's sort of pricing in roughly where it expects and when it expects some of these things to happen and how long the market believes that it's going to be before the Fed actually starts raising short-term interest rates, as well.
I don't think that the panic that a lot of investors have been feeling is probably as warranted maybe as people think it is. However, there is a basic fact that with the rates so low, you're really not getting that much income from your bond investments right now. And so, that does create some risk that if you do see a spike in yields, market misses, what have you, it could wipe out the income return that you otherwise have.
So, especially with people having chased yield as much as they have, it does make investing in bonds probably a little bit riskier than it otherwise has been over the last few years.
Benz: Does that mean that investors should just avoid bonds altogether because that is something I hear from some investors? They see these headwinds for fixed income, they say, "I'm just going to own stocks and maybe earmark the money that I would otherwise hold in bonds and hold that in cash instead." What do you think of that strategy?
Jacobson: There are two dangers. One is the example you gave. Another is people just wind up buying more stocks. That really worries me a lot when people go that route because I think it fundamentally changes the risk profile of your portfolio. Stocks, in general, are expected to be a lot more volatile on a day-to-day, month-to-month basis than you would expect bonds to be. Lots of things can happen in the stock market that are divorced from the economy, at least, on a day-to-day basis. And so, if you wholesale move in the stocks, you really, really are taking potentially a lot more risk than you otherwise would.
As far as moving a lot of money into cash, again, it goes back to this question of how long this is going to take for bond yields to eventually rise, whether or not they rise very much over a very short or a long period of time. And the danger of cash is that as long as we have even some inflation, and cash is yielding next to nothing, your real return, your afterinflation return is actually negative on cash at this point. Your purchasing power just erodes. I think people instinctively hear that kind of warning and say, "Yeah, but I'm talking about over the next year. I'm not talking about over 10 years, the purchasing power." Well, the fact of the matter is a lot of people started thinking about this kind of thing three, four years ago and thinking that they should just start holding cash. And those that have, have already lost purchasing power, and those that do it could be sitting around on the sidelines for a quite a while waiting for this to happen.
The forecasts right now are that we probably won't see short-term interest rates go up maybe until 2015, 2016 depending on who you listen to. It could be a while before any of that happens, and your money is just really sitting around losing value if you hold it in cash too long.
Benz: Eric, thank you so much for providing an overview of bonds and bond funds in 2013. Thanks so much.
Jacobson: Always it's my pleasure, Christine. Thank you again for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.