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By Christine Benz and Eric Jacobson | 12-19-2013 04:00 PM

Think Twice Before Ditching Bonds

Although many fixed-income fund categories had a rocky 2013, investors should heed the dangers of swapping their bonds for cash or stocks, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I am Christine Benz for Morningstar.com. As equities soared in 2013, bonds logged a forgettable year. Joining me to recap the year in bond funds is Eric Jacobson. He's a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: It's always great to be with you Christine, thank you.

Benz: Eric, generally speaking, it was a year to forget for fixed-income funds, but there were a couple of pockets of strength. Bank-loan funds and high-yield funds led everybody else by a long distance. Let's talk about the key drivers for those categories.

Jacobson: I think that there are two sides of the coin. One is that both categories performed reasonably well over the summer, when the bond market sold off quite a bit mostly driven by rising yields on the high-quality bonds, Treasury bonds, what have you. And because of the fact that bank-loan funds have very little interest-rate sensitivity, and high-yield funds have a little bit of more, but still not very much, and [the fact that there was] a lot of income coming off of [these types of funds], they were reasonably well-insulated from what happened.

The other side of the coin is that the economy--even though there are still some questions as to whether it's really reached what you might think of as escape velocity from where it's been--has been reasonably healthy and default rates have been relatively low. As people have probably heard, there's lot of cash on corporate balance sheets, et cetera. And so that's been a good backdrop for real credit-sensitive instruments.

Benz: I have a related question for you, Eric. You mentioned that the fundamentals are looking pretty good for these two groups. But do you think that there is an element of yield-chasing that's going on here, as well, and that is pushing up demand for the bonds?

Jacobson: There's no question about that, certainly. I think, another way to put it is that, some of that thinking about where the economy stands, you could even interpret as a little bit of rationalization because people are saying, "Well, the yields aren't very high, but I'm still going to buy it because the economy is doing OK and the fundamentals look good."

I do think that there is some thought among folks in the investment universe that things became a little more fairly valued when yields spiked up over the summer time. But in general, I think there's a broader sense that things are quite dearly priced when it comes to some of these sectors that are traditionally yield generators.

Benz: At the other end of the spectrum, anything that was very interest-rate-sensitive had a very weak year. Let's talk about the drivers there.

Jacobson: That again was very much driven by what happened over the summer. As you know when the Fed signaled some talk about when it might start tapering the quantitative easing program, the market reacted very strongly. We saw a relatively large spike in interest rates. The 10-year Treasury went from about 1.63% in early May to up to about almost 3% by early September. That really had a very strong effect on returns for the overall year, especially for the more rate-sensitive types of the market.

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