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By Christine Benz and Michael Rawson, CFA | 03-12-2014 10:00 AM

Investors Flock to Foreign-Stock and Noncore Bond Funds

As rising rates and emerging markets lose momentum, fund investors are eyeing nontraditional fixed-income categories and European and Japanese equities.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. After losing assets for much of 2013, flows into bond funds picked up steam in February. Joining me to discuss the latest asset-flows data is Michael Rawson; he is a fund analyst with Morningstar.

Mike, thank you so much for being here.

Mike Rawson: Great to be here.

Benz: Mike, I guess, I wasn't surprised to see that equity funds saw fairly decent flows in February. I was surprised to see that taxable-bond funds and even municipal-bond funds saw some inflows during the month. What do you think is driving that?

Rawson: I think it's really the uptick in rates that we've had. At the end of 2013, the 10-year rate hit about 3%. That starts to look pretty attractive, relative to what we've seen in the last couple of years. I think a lot of the investors who are selling bonds in anticipation that rates would rise, are thinking, "OK, rates have already risen. I'm not going to continue to sell bonds."

I think there has been some stabilization there.

Benz: Investors think maybe the worst is over in terms of rising rates?

Rawson: At least in the short term, I think so. It's hard for me to envision the 10-year rate going up above 3% to 3.5% or 4%. I think that's little bit too high given that the Fed is still anchoring short-term rates near zero percent, so I think we'll probably tread water here at this level for some time.

Benz: Let's talk about the types of bond funds investors were buying. The intermediate-term bond category, you noted, still saw pretty tepid inflows, if positive at all. But some other categories were generating interest.

Rawson: Yes. The core-bond fund categories, there were essentially no flows. It was flat, but the noncore categories which we talked about a lot over the last several months--nontraditional bond, bank loan, high-yield bond--these are categories which are just continuing to see inflows. In fact high-yield bond had a very strong month last month, and I think there it's people are looking for some protection against rising rates and some credit spread to give them a little bit of extra income.

Benz: That nontraditional bond category, you have noted has been seeing a lot of interest, but PIMCO's fund, which had been one of the biggest asset gatherers, actually has been seeing some outflows?

Rawson: Well [PIMCO Unconstrained] was so popular, it's one of the reasons why we kind of created the category several years ago, and it was the category leader. However, it fell in hard times last year. People were buying this fund thinking, "If interest rates go up, my bonds are going to lose money. I got to prepare for that. So I want to go into something defensive."

This was sold as a fund that would do well if interest rates did go up; then it didn't hold up. In fact it had a negative return over the past year, so investors have been fleeing the fund and saying, look this isn't what I signed up for. They are going into couple of other funds, those include [JPMorgan Strategic Income Opportunities, BlackRock Strategic Income Opportunities, Goldman Sachs Strategic Income], so these are funds that actually had positive returns over the last year and are billing themselves the same way that they are going to hold up better if rates rise.

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