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By Christine Benz and Eric Jacobson | 05-22-2013 04:00 PM

Watch for Asset Bloat in These Bond-Fund Sectors

Investors should be cautious of rapid inflows into high-yield and bank-loan funds as managers could have difficulty putting excess money to work in high-conviction ideas.

Christine Benz: Hi. I’m Christine Benz for Morningstar.com. As investors have flocked to higher-yielding bond categories, asset growth could be problematic at some of these funds. Joining me to discuss this topic is Eric Jacobson. He is a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Sure, Christine. Glad to be with you.

Benz: Eric, we’ve generally said that investors shouldn’t get concerned about big asset inflows into some of the general bond categories, core intermediate-term funds, for example. Let’s talk about why that is. Why can managers of such funds typically handle a lot of assets without it compromising their performance?

Jacobson: I think that the rule of thumb is that the more plain-vanilla a portfolio and its strategy are, generally speaking, the easier time it is going to have absorbing that ton of cash, mainly because the big sectors represented in the broad bond market indexes are very, very liquid. We’re talking about Treasuries; we’re talking about agency-backed mortgages. Even the corporate investment-grade market, which is smaller and a bit less liquid than the others, still generally has a lot of capacity in order to absorb that cash, and funds with a lot of resources can also use derivatives sort of as a placeholder while they’re putting that money to work. That may not always be what you want to see if they’re doing it for a long period of time. But there are tools that they can use, like I say, to absorb that cash, and it’s a lot easier for a core fund.

Benz: Once you step beyond those core, very vanilla-type funds, you say that there might be actually some risk in these big asset inflows. I’d like to start by looking at some of the categories that have recently seen some of the biggest flows. One is this nontraditional bond category. It’s a new category for us. First, let’s discuss what that category is? And second, let’s discuss why you think in some cases flows could be problematic?

Jacobson: One of the interesting things about the category is that it’s a little bit more defined by what the funds are trying to do than what is in them, and I’ll circle back to that in a minute. Most of these funds are trying to produce some sort of what we might call an absolute return. In other words, just beating a very basic benchmark like Libor by a certain amount each year with the hope of not generating negative returns. And as we’ve talked about before, the most common way to try and do that in this environment has been limiting interest-rate risk. So, in many cases what managers are trying to do is, is sort of sell it as an all-weather portfolio or diversion of something else that they already manage, just without interest-rate risk in the hope that they can deliver a steady return.

Now going back to what I said before about what’s in the funds, that makes a big difference, and some of them have very different features than others. Some of them have lots of credit risk. Some of them take on more structural risk we might call it. The Putnam funds that are in the category, for example, use mortgage derivatives to generate more yield and to try and generate more consistent yield than some of the other portfolios. And some of them, as I suggested earlier, are sort of broad multisector core funds and drag almost. PIMCO Unconstrained Bond, not necessarily core underneath completely, because it has flexibility to take on more credit and emerging-markets risk, but it’s sort of the best-ideas fund. It has a very large set of tools at its disposal. And it is not necessarily concentrated in the higher-yielding, lower rate-risk areas of some other funds, but it does hedge its interest-rate risk out.

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