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By Christine Benz | 01-12-2012 02:00 PM

Steering Your Bond Portfolio in 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?

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