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By Christine Benz and Eric Jacobson | 02-28-2013 03:00 PM

Where Bond-Fund Skippers Are Sailing

A number of core bond-fund managers have moved away from Treasuries and toward opportunities in emerging markets and mortgage-backed securities.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With many investors scratching their heads about what might be next for the bond market. We decided to take a closer look at where active bond portfolio managers are placing their bets. Joining me to discuss that topic is Eric Jacobson. He is a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine. Great to be with you.

Benz: Eric, you took a look at where intermediate-term bond managers, those who have active strategies, are positioned relative to the benchmark Barclays Aggregate Bond Index, and as you looked across some of these positionings you actually came up with a few themes that you noted. One is a general tendency toward emphasizing credit-sensitive parts of the bond market. Let's drill into that a little more deeply and find out what you found.

Jacobson: Sure. Well, I think if you look at the breakdown of intermediate-term bond funds relative to each other and to the benchmark, what you'll see is this tendency in particular to hold fewer Treasuries and much more in terms of as you say credit-sensitive bonds. I say [credit-sensitive bonds] instead of just saying corporate bonds because all you have in the index are investment-grade corporate bonds, you have a little bit of other stuff, a small allocation to commercial mortgage-backed securities, but you don't have a lot of the other ancillary things that funds sometimes invest in that are outside of that narrow scope, including for example, high-yield bonds, which have found their way into the core bond area, the broader group of taxable-bond funds, specifically intermediate-term bonds.

Benz: So, do you think it's that some of these bond managers are just saying the high-yield is a way to pick up a little bit of extra income and maybe look competitive or are you hearing from fund managers that they actually think the high-yield sector is still attractive?

Jacobson: I think we're not hearing that as often as we were maybe a year ago. Certainly I think there is a recognition that, that spreads are getting tighter. You're starting to hear managers talk about it being more the bond-pickers market than a broad opportunity because spreads are particularly wide. But let's face it, there is also a general need on the part of bond managers to compete with each other based on yield.

So, it's very difficult sometimes to suss out just how much of that is a true and believable assertion that, "Yeah, we think everything looks great and cheap that's why we are buying it." Or "Are we buying it because the money is coming in. We've got to put it at someplace. We want to make sure we keep our yield high enough to attract investors."

I hate to ascribe anything that sinister to fund managers. You don't seem to necessarily find it on a one-by-one basis, but we know in a broader sense that that's kind of how the market sometimes works.

Benz: Another area that you identified that some of these active bond managers have been adding to or had that's certainly not represented in the Barclays Aggregate Bond Index is emerging markets. Let's talk about how widespread that practice is and also, if you have any sense for the motivations for fund managers who might be buying emerging markets right now.

Jacobson: I would say it's widespread enough that it's worth mentioning. It tends to be a little lumpy. I mean you don't find it everywhere in the category, but where you do usually find it is sort of an important thesis. PIMCO Total Return is the flagship. That's the one we often think about and hear about, and it plays such an important role in the category as a trend-setter. And the fact of the matter there is PIMCO has been arguing for long time that the best growth prospects and the healthiest balance sheets are in the emerging-markets economies. And even though PIMCO has taken down some of the risk in its portfolios over the last year than it had prior, it still has a healthy allocation to emerging-markets debt, and that is a sentiment that you see peppered into other portfolios across the category that you probably would not have expected to find a few years ago.

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