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

Take Care With Core Bond Exposure

Core bond funds have cut their interest-rate sensitivity relative to their benchmark, and Morningstar's Eric Jacobson says the dramatic changes in correlations have skewed common metrics, such as beta.

Christine Benz: Hi. I'm Christine Benz for Morningstar. Although many core bond funds use the Barclays Aggregate Bond Index as their benchmark, in recent years more and more core bond funds look nothing like the index. Joining me to discuss that phenomenon is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

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

Benz: Eric, you recently wrote a commentary--it was quite thought-provoking--where you discussed how core bond funds have really gotten pretty far away from the Barclays Aggregate Bond Index in recent years. Can you discuss generally what you found?

Jacobson: Yes. We've noticed this in sort of a creeping fashion for quite a long time, ever since the financial crisis. What we've seen, though, is that a lot of managers have owned fewer Treasuries, which isn't that much of a surprise, but we've also seen overall that has meant a lot less interest-rate sensitivity at the fund level. And we've seen managers either building up areas of the market that are lightly represented in that core index--the Barclays U.S. Aggregate that we use as the lodestar, if you will--or going into areas outside the index entirely. In some cases, they're building up relatively large weightings there.

So when we took that as our base information because we know it's true just from looking at the funds, and then went back and looked at some correlations and what we call R-squared--the other statistic that bakes all that together--we found that whereas in previous periods prior to the crisis, you used to have a very, very high correlation of funds to the index, in some cases, on a scale of 1 to 100 where 100 is the highest R-squared, if you will, you'd have funds frequently in between 95 to 100 most of the time. You're finding now that that's just not the case any longer.  

Benz: So, these are actively managed funds, too, with very high R-squareds, but that has changed?

Jacobson: That's correct. They've always been actively managed funds, but because they've been closely aligned with the index, and very tightly bound in many cases in terms of interest-rate sensitivity, their correlations tend to run very, very high.

Benz: So, you mentioned, Eric, it's probably not surprising that active fund managers would be downplaying government bonds, but just walk through what is the thought process in driving that change?

Jacobson: There are two things going on. One is that the index itself has become much more government-centric with explosion, if you will, in Treasury issuance that many people are probably aware of just by virtue of the fact that we've got so much government borrowing going on. In addition, most of the mortgage market is now underneath the auspices of Ginnie Mae, Fannie Mae, and Freddie Mac, and even though Fannie and Freddie aren't technically government entities, they are essentially under the umbrella of the government. So even though mortgages do act a little bit differently than Treasuries still, you've got this huge percentage of the index that's very, very highly tied to the government. So you've had managers say, "Even though this is our index [Barclays], and this is the one we've been using all along, these are unusual times. We shouldn't necessarily feel compelled to be right on top of it, either in terms of interest-rate sensitivity, which is very highly affected by where the issuance is in the government market, or by the sector allocations that are in there, which are being distorted, of course, by what's been going on, as well."

Benz: You mentioned that you have observed several funds where there was once a very high correlation in terms of performance and maybe portfolio positioning relative to the index and that has drifted downward, can you provide any examples of funds that have demonstrated this trend?

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