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By Christine Benz | 03-26-2012 01:00 PM

Are Rising Rates a Forecast for Storm Clouds?

Many investors cut back on interest-rate exposure in the first quarter as Treasury uncertainties and inflationary fears grew, according Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Bond funds notched decent gains during the first quarter of 2012, but there were some storm clouds looming on the horizon. Joining me to discuss some of the latest trends in bond-fund performance is Eric Jacobson. He is director of fixed-income research with Morningstar.

Eric, thank you so much for joining me.

Eric Jacobson: I'm happy to be with you, Christine.

Benz: Eric, during the first quarter, investors, at least toward the end of the quarter, appeared to be a little bit nervous about rising rates, and some of the most rate-sensitive bond sectors got knocked down pretty hard. What was going on there, and what were investors responding to?

Jacobson: Well, there has been a lot going on, as you know, with not only government policy but also in terms of economic indicators showing a little breath of life there. The overall numbers for last year were strong relatively speaking in terms of the Consumer Price Index. I think we're getting to the point at which there is starting to be a little bit of concern about inflation actually occurring. Well, we know it's occurring; we've seen it in gas prices. The real longer-term question is whether or not it produces some real growth.

So we've had these reasons for pessimism sort of building, including, as I said, government policy. The Federal Reserve talked a little bit in January, I believe, about what its targets were going to be going forward, and that, I think, really reset expectations. Things have just started to percolate up in the last several weeks in terms of government yields, which are starting to trickle up a little bit, if you will.

Benz: Long-term government bond funds were obviously pretty hard-hit during this period and had the worst gains among bond fund categories during the quarter. Were there any other pockets of the market that performed especially poorly due to rate-related jitters?

Jacobson: No, the government funds really took the brunt of it, and in fact the most interesting thing about the way you phrase the question is that some of the traditional areas you might have expected to do poorly, perhaps not as poorly as long-term government bonds, but namely the more rate-sensitive sectors like the municipal-bond market and even your core fund areas, have not done that poorly. In fact for the year to date even though the bonds had a rough month so far in March, the Muni National Long-Term category was actually up about 2.6% for the year to date through March 25.

That goes against a long-term government category change of about minus 5.7%. So what you've had there is a much longer story, of course, because municipals have sort of decoupled from the rest of the Treasury market ever since the financial crisis. But what we've seen is that they have started to move along with the rest of, what we call, the risk assets in a sense that when investors are seemingly more comfortable going out to more risk, they are treating municipals in that same bucket, which is not how things used to be.

Benz: So you mentioned the risk assets as having performed relatively well during the quarter. It looks like high yield had a very good quarter as well as bank-loan funds. So is that sort of the flip side of that same coin where investors are feeling perhaps a little more optimistic about the strength of the economy and a little bit more willing to take that credit risk?

Jacobson: Yes, I think it is all of those things woven together, if you will. To some degree, I think there is a question, of course, as to how comfortable people feel with risk, but they feel that they are being left with no choice because of the fact that yields are so low in Treasuries and that combined fear that they are going to tick up. They don't see a lot of value in the Treasury market necessarily regardless of what you think about whether or not rates are going to rise significantly more from here; and that is a question of some debate too. But people are feeling like whatever is going to happen there, those numbers are just too low.

So when the time looks relatively ripe and things in Europe are relatively stable and not scaring the pants off everybody, if you will, as we've seen over the last year or so, that tends to go to this what we've been calling the risk-on market trend, in which case you wind up seeing these so-called risk assets rally, such as you mentioned high yield and bank loans as well as emerging-markets bonds.

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