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By Jason Stipp and Michael Rawson, CFA | 03-13-2013 11:00 AM

Despite Stock Rally, Investors Still Like Bonds

Taxable-bond funds led open-end asset flows in February, with investors showing interest in emerging-markets bonds and bank-loan funds.

Jason Stipp: I’m Jason Stipp for Morningstar. After a strong January, February also saw strong inflows for long-term open-end mutual funds. So where were investors putting their money to work? Here to offer some insights is Mike Rawson, fund analyst with Morningstar.

Thanks for joining me, Mike.

Mike Rawson: Great to be here.

Stipp: January was a strong month; February was pretty strong, but not as strong as January. What was the top line number on the inflows for mutual funds?

Rawson: It was about $50 billion. January was closer to $90 billion. January was the strongest month we've ever had in terms of fund flows. It got everyone excited about this [idea that] now it's a great rotation--people are going to start buying stock funds again after so many years of redemptions and people selling stock funds.

Things moderated a little bit in February, so we have to back off that story. But they were still strong flows, particularly strong again into fixed income and international stock. U.S. stock funds not so much, kind of lackluster, but they were positive, which is a good sign.

Stipp: So bond flows still looking strong, on the stock side maybe not so much. What about when you add ETFs in, though? I know investors have been looking increasingly to passive investments; ETFs are mostly passive. Does that make the story seem better for stocks?

Rawson: ETF flows last month were about $8 billion, [compared with] about $50 billion on the mutual fund side. We've seen this continuation of investors’ preference for passive products. So, passive mutual funds and passive ETFs have continued to grow and have had stronger flows. Actually we saw outflows from actively managed U.S. stock funds last month; [they were] small, and those were offset by the flows into passive products. So, investors continue to prefer ETFs primarily because they're passive and they're low cost, low-expense-ratio products.

Stipp: … Can you talk about why you think we're still seeing money go into fixed income? Now that the market has been up, it seems like there is some enthusiasm for stocks. Also, concerns start to creep in about interest rates going up and the Fed being less accommodative. But people still prefer bonds. What's behind that?

Rawson: So, going back to December, there were some hints that some of the members of the Federal Reserve's Open Market Committee were more inclined to cut back on quantitative easing sooner rather than later. Bernanke has come out several times saying, no, we're going to maintain the quantitative easing. But interest rates have ticked up slightly since December, and that [could have] spurred people to think, OK, now we're starting to [see interest rates] rise, so it’s time to get out of bonds. We haven't seen that. People still prefer bonds.

What we have seen, though, is people starting to move out of government bonds and move further out on the risk spectrum--whether it be emerging markets or bank loan funds. In fact, historically, intermediate-term bond funds were the strongest category. But last month, [investors] cranked the risk up a little bit more and went into these bank-loan funds.

I think bank loans are kind of interesting, because there you have the potential that if interest rates do rise, bank loans are typically floating rate. So, they could help investors a little bit if rates do start to go up. They also have some credit risk; credit risk products have been doing well, so bank loans have had pretty strong performance, and they saw very strong flows last month.

Stipp: Given the flows that you're seeing into some of these categories that may be more exotic to traditional fixed-income investors, such as emerging-markets bonds or bank loans, do you feel like investors know what they're getting into when they're getting these products? As you said, there is some credit risk involved.

Rawson: Well, I'm not sure if they know what they're getting into, but I wouldn't say that they're taking on too much risk. Still you have the equity market at a reasonable valuation. I think bonds are reasonably valued when you look at Treasury bond rates. If Treasury bond rates are 2%, then you're going to have low rates on high-yield bonds and corporate bonds as well. The whole yield curve is going to come down for all products.

And you have people like Bill Gross of PIMCO out there talking about how you've got to diversify your bond portfolio and get some exposure--whether it'd be non-U.S. dollar corporate or outside of just Treasury bonds.

So I don't think we've seen excessive speculation at this point.

Stipp: And if an investor is moving some of their traditional fixed income into some of these other categories, what would you say [you should] keep in mind if your diversification in bonds is going to include some of these other categories? What might you see maybe in the short term that you should understand?

Rawson: The big thing they need to understand is that when you think about your whole portfolio, your asset allocation, you've got stocks and bonds. The role of bonds in your portfolios really is not to earn an excess or huge return. You're not going to strike it rich investing in bonds. [Bonds are] there to be a counterbalance to market volatility. You want that to really be very stable.

So, if you start to take high-yield or emerging-market risk, those tend to be more correlated to the economic cycle, to equities. So if the equity markets do sell off, those bonds may not hold up as much as you thought when you were designing the 60-40 bond-stock portfolio. So, investors really need to be aware of what is the role of bonds in their portfolios.

Stipp: Mike, let's talk a little bit about some of the fund families that came out well in February. Who is continuing to do well? What are the trends you are seeing there?

Rawson: Sure. Well, as we saw in 2012, all of last year, it's Vanguard and PIMCO across the board; they're just dominating. Vanguard, it's easy to understand. People want index products. Vanguard, of course, is the king of indexing, and they also have a strong ETF lineup, so Vanguard is continuing to gain share on the ETF side.

For PIMCO, it's been investors, again, wanting bond, so PIMCO, of course, has a lot of bond fund offerings. But PIMCO also offers a lot of these alternative, niche, higher-risk bond funds. In fact, last month this PIMCO Unconstrained Bond Fund was very strong; it had over $2 billion in flows. So PIMCO's whole suite of products have had really strong inflows.

Stipp: So despite a strong month in the market, new highs in the market, we're still seeing a certain preference for bonds among investors. Thanks for joining me today and giving me some insights on that fund flow data.

Rawson: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp.

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