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By Christine Benz | 12-17-2010 05:28 PM

2010 Scorecard for Bond Funds

Morningstar's Eric Jacobson reviews bond fund performance and fund flows in 2010, analyzes recent performance hiccups in fixed income, and pinpoints the factors that should be on bond investors' radars today.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

Despite some recent performance troubles, bond funds have had very good returns so far in 2010. Here to provide some color on what's been going on in the bond world is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thanks so much for being here.

Eric Jacobson: Glad to be here. Thanks, Christine.

Benz: So, Eric, let's talk about bond funds as a group; they've performed really well, but what have been some of the better-performing categories within this asset class.

Jacobson: Pretty much anything that had a generous amount of income or yield performed really well. And the most obvious reason for that, I think, is that the Fed has kept short-term interest rates very low; they have done a lot of things to keep interest rates relatively low across the board. A lot of factors like that have really triggered a tendency among investors to look for higher-yielding assets to provide income. And so anything with a lot of income, high yield for example, has done really, really well over the course of 2010.

Benz: And in general, the longer you've been, the better off you've been, until very recently.

Jacobson: By and large that's correct, also, because the yield curve, if you will, the spectrum of maturities from short- to long-term bonds has been what we say is relatively steep.

So, in other words, if you go from left to right, from the shorter to the longer maturities, the yields have been higher at the long end than at the short end. So, that steepness makes long maturity bonds more attractive simply from a yield perspective. Although people have to remember, of course, that there is more interest rates sensitivity, there is more volatility.

Benz: Right. So, in general risk has been rewarded so far in 2010. In terms of categories that haven't performed as well, is that pretty much the flip-side--so anything shorter term or taking less risk performed relatively less well?

Jacobson: Absolutely. Again keeping in mind that we're speaking about the year in general, that's absolutely correct. As you said, the shorter maturity sectors have not performed well. The muni market in fact leaned a little bit on what we are talking about in terms of things that have happened in the last month, but also in general, the yields on municipals have been relatively low versus history in terms of the raw numbers, and that has made it difficult, I think, for them as well--people not as interested in them. So municipals, if you look at it over the course of the year, not as good, and certainly the very short term stuff--ultrashort, short term bond--have not performed especially well as one would expect.

Benz: Right. You're not earning much on your cash. You shouldn't expect to earn a lot more on short-term bonds.

Jacobson: That's right.

Benz: Okay. So, Eric, we've seen this stampede of assets going into bond funds. Let's talk about where they've been going. And I understand there's been a little bit of a pullback recently, but year-to-date very robust flows into bonds overall.

Jacobson: That's right. If you look at the three categories that have seen the largest inflows over the course of 2010, they have all been fixed-income categories.

Benz: So, across the whole mutual fund universe, they are all going into bonds?

Jacobson: Exactly. The intermediate-term bond category, which is the home to what we think of as the core universe of bond funds, including PIMCO Total Return, the big daddy, if you will, enormous flows, both last year and this year, but the largest of any mutual fund category at all for 2010 at about $74 billion, something like that.

Benz: Okay. You said short term bonds also ...

Jacobson: Short term bonds and in fact world bonds, which has been sort of a big story this year in terms of people flocking overseas, looking for more income as well.

Benz: So, that's a little counterintuitive, because arguably the eurozone has more financial problems right now than here in the U.S. What's driving that quest into world bonds?

Jacobson: Well, part of it is that we're talking about different time periods. So, there have been times at which those bonds have looked particularly cheap, flows have been strong. The other issue is that, a lot of world bond funds haven't necessarily been focused only on Europe, certainly.

There have been managers who have been very excited about what they see available in Asia, and a number of world bond funds hold a reasonably significant stake in emerging-markets debt. And the interesting thing there, of course, is that some of these emerging-market economies that we still call "emerging markets," they are by many measures, but their credit quality is improving, their underlying fundamentals, the sovereign balance sheets have looked good. So, those kinds of markets have found their way into the world bond category. So, I am not saying that it's necessarily all smart money that's done this, but there have been some sound reasons that managers have chosen the markets they have and that people have chosen to buy world bond funds as well.

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