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By Christine Benz and Eric Jacobson | 04-25-2012 02:00 PM

Bond 'Liquidity Storms' in the Forecast

Money has been quickly pouring in to and out of risk assets in the bond markets recently, making for a volatile ride.

Christine Benz: Hi, I'm Christine Benz for

Stocks posted tremendous gains in the first quarter, but bonds were decent, too. Joining me to discuss the recent trends in bond market performance is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Great to be here. Thanks, Christine.

Benz: Eric, it was actually a fine quarter for bonds in the first quarter, but it definitely appeared that investors were embracing credit risk over interest rate risk during the period. What was driving that trend in your view?

Jacobson: I think there are few things going on. One is that, we finally tapered off from the big rally in Treasury bonds last year. People started looking, I think, at the yields and agreeing that they were getting to be sort of unsustainably low, especially given that the other side of the coin was that Europe quieted down, things from Europe didn't seem to be as great a risk as they were before, and U.S. economic data started looking up.

And all those things, I think, backed up this idea that, as things have been going in the last year or so, more of a risk-on rather than risk-off kind of bond market. And anything that had some level of credit or, as we say, spread risk--risk above and beyond that of Treasuries--did really, really well in the first quarter of 2012.

Benz: So, let's delve into the categories that you would count among the best performing in the first quarter?

Jacobson: Well, the faraway leader was the emerging-markets bond category. And as you know, the flows there have also been very strong. The interesting thing about that category is that pieces of that market have been finding their way into more diversified funds as well. We've talked number of times about the fact that there are some emerging markets, for example, even in PIMCO Total Return, and firms that have that capability are looking to find ways to use it.

When you hear PIMCO talk about it, they look at it almost as a ... I hate to use the term "paradigm shift" ... but that's kind of what they're saying in effect--that emerging-market balance sheets are stronger, they have more flexibility in terms of their fiscal and monetary situations, and that they are just better places for your money right now, but clearly when you look at the history of the emerging-market bond category, there is plenty of risk there, too.

Benz: Right--junk bonds also had a very good period. What was driving that? Just the risk-on mentality as well?

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