Christine Benz: Hi. I'm Christine Benz for Morningstar.com.
The Barclays Aggregate Index is the key benchmark for core intermediate-term bond funds, but increasingly the typical intermediate-term bond fund looks nothing like the index. Joining me to discuss that topic is Eric Jacobson. He's 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, let's discuss how funds are looking different from the index. What types of fund are making these bets, and what types of bets are they making?
Jacobson: I would point out that a lot of them are funds that we tend to highlight and tend to be well-known and popular with investors. What several of them are doing is staying a little bit shorter in terms of their duration, and owning more and more things outside the index.
One notable exception would be PIMCO Total Return, which came into the latest rate sell-off with a much longer duration than many of its peers and was longer than the benchmark. Unfortunately, Bill Gross was just wrong about what he thought was going to happen in terms of the tapering and the language that surrounded it.
But the other funds that I'm thinking of--for example, Metropolitan West Total Return, Dodge & Cox Income, DoubleLine Total Return Fund, TCW Total Return--almost all of them were pretty well short of the index, and all hold one thing or another, such as residential mortgage-backed securities in the case of MetWest, and some of the funds have more emerging-markets exposure. PIMCO, even though as I said they sold off pretty badly, that was one of the areas that they have gone outside the index.
So, you're seeing a lot of managers trying to not only bring the durations down a little bit, but find other areas of return.
Benz: So they're not emphasizing Treasury and other government-backed bonds to the same extent that the index is?
Benz: You note that apart from the actions that managers are taking, the index itself has also changed in terms of its composition and its duration. Let's discuss how that fits into all of this.
Jacobson: That's a really big issue right now. It's not something that's getting talked about quite as much, but the mortgage component of the aggregate has really extended dramatically in the last year. A lot of that has to do with the fact that, as prepayments have been slowing down, partly because interest rates have been going up, the duration on just the mortgage subset of the index has gone from about 2.25 years last September to almost 6 years this September. That's a huge, huge extension, and that has had a very big impact on the overall aggregate, which … got to about 5.6 years in September of this year. That's about as long as it's been for a very, very long time.
Benz: Eric, let's just back up and discuss why that happens. If rates look like they may trend up, mortgage holders say, I'm going to hang on to this low-rate mortgage, and that in turn extends the duration of the mortgage pool in the portfolio?
Jacobson: I would flip it around even, and say that the bigger issue is prepayment speeds. The slower the prepayment speed, the longer it's going to take for those mortgages effectively to be called--we don't talk about it that way, but that's the analog to corporate bonds or municipals. If that call or prepayment is not going to happen for a much longer time, it pushes the cash flows out longer and longer, effectively lengthening the maturity of the mortgage and bringing its duration out.
Benz: Backing up to this point about intermediate-term bond funds increasingly getting into areas like emerging-markets bonds and more credit-sensitive bonds, is there a risk that the bond fund that an investor might look to for ballast to offset swings in their equity holdings might not really do that--that it might not offer that low volatility that investors often look to their bond funds to provide?
Jacobson: I think that's a risk. It isn't fully developed yet … from the perspective that the weightings have not gone through the roof. But you certainly have a different dynamic in how funds like that are going to behave in credit-driven volatility or sell-offs. I think it's definitely something for people to consider--the fact that what they view as their ballast or, in fact, what's going to perform well when Treasuries perform well, for example, isn't going to be as helpful to them if that part of the portfolio is acting a lot more like, say, emerging markets or high-yield.
Benz: I know a lot of investors just like to index the fixed-income portion of their portfolio and call it a day. Can we discuss the pros and cons of that strategy, especially given that, as you say, some of the smart money seems to be positioning against the index and doesn't want to look like the index?
Jacobson: It's really, really hard to make blanket statements about it, because of the fact that calling interest rates is so difficult. Even when you look at the experts--Bill Gross, even--has gotten it wrong in the short term. It's the kind of thing that it's hard to give much advice [about] or warn people. But the bottom line is, the index is not quite the same to the bond market as the S&P 500 is to the stock market in the sense that, in a way, the S&P 500 is a measure of success in the economy and the success of companies. It can certainly become overvalued, but you're essentially measuring something a little bit different than you are on the bond side, which is that, on the bond side it's really a reflection of how much debt either the government or the mortgage market, or the corporate markets are taking on. At that point, the dynamics are very different. It's not being driven by some fundamental characteristic that you'd necessarily want to pattern yourself after.
So that being said, what is that [bond index] fund going to look like and what is it going to imply for you? What it's going to look like right now is a fairly long-duration instrument. When I say long, I don't mean out to 10 years or anything. I'm talking about roughly 5.5 years of duration right now, say, for the Vanguard Total Bond Market Index.
Benz: Can we talk about how funds, both index trackers as well as active funds, performed during that interest rate shock that we had this past summer?
Jacobson: Unfortunately, it doesn't turn out to be the best time period for measurement, because of the fact that pretty much everything sold off during this period. So, it's harder to isolate the effect of rising Treasury yields versus the sell-off in the credit markets, because both did somewhat poorly. One of the reasons for that is the fact that going into this period, credit spreads (in other words, the difference between Treasury yields and credit-sensitive bonds) were very, very tight. That made the credit sensitive parts of the market much more sensitive to interest-rate shifts.
The bottom line is that even funds that were a little bit shorter weren't quite as successful in the Treasury market sell-off as you might have imagined because of the credit risks that they were taking on. So, everybody pretty much in the core space got hurt by this. If you look at the non-traditional bond category that we've talked a lot about before, I would say they were marginally more successful, maybe by a percentage point. But a number of those funds still lost money, even though they were very short by comparison in terms of duration, in many cases because of the credit risk that they were taking on.
Benz: Does that suggest, though, Eric, since everything sold off at once, that a lot of this maneuvering around may be for naught, if we have a sustained period of rising rates? Or is it just totally dependent on the type of market environment that plays out?
Jacobson: I really do think it depends a lot on where we are at the time that rates move and spike up, or to the degree that they do spike up over a short period of time. But in a more normalized market, where the spreads of more credit-sensitive bonds are wider and the economy is doing better, then you'd expect to have more sensitivity in Treasuries, worse returns among longer-duration Treasury instruments, and better returns among credit-sensitive bonds.
The last time we saw a really good example of that was probably 1994, obviously a very long time ago. But what we had at that point was a growing economy that was actually driving rising rates, and so you saw a little bit more of that distinction.
Benz: Eric, I know a lot of investors are very concerned about the bond part of their portfolios right now. Thank you so much for being here to share your insights.
Jacobson: It's my pleasure, Christine. Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.