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By Christine Benz and Eric Jacobson | 03-28-2014 12:00 PM

The First Quarter in Bond Funds

The fact that bonds outpaced equities in the first quarter illustrates their important role as diversifiers, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

With the first quarter of 2014 winding down, many investors may be surprised to see their bond funds outperforming their stock holdings.

Joining me to provide a recap of the first quarter in bond funds is Eric Jacobson; he's a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: My pleasure, Christine. Good to talk to you.

Benz: Eric, let's start with the headlines. When you look across the bond fund categories for the first quarter, what were the big leader and laggard categories? Let's start with the leaders.

Jacobson: The big standout was a small category--not a lot of people own it, but you see this affecting your other funds--long-term government. The average for the year-to-date in that category was more than 8.3% positive total return.

[The category performance trend then] sort of goes down a logical progression, all the way down. The short-term bonds, ultrashort bonds, anything that didn't have a lot of interest rate sensitivity--including non-traditional bond, which includes the very popular unconstrained strategies right now--all are roughly near the bottom of the taxable-bond universe.

On the muni side, it kind of breaks down by state, but the national funds did pretty well, returning almost 4% for the year-to-date.

Benz: In the muni space, did the long-term funds do well?

Jacobson: Yes, they did.

Benz: Let's talk about that, Eric, because a lot of investors for a couple of years now have been bracing themselves for this interest rate jump. We did see one this past summer. But Federal Reserve Chairperson Janet Yellen indicated that the Fed would continue its tapering program, that it was in fact on course. So one might have thought that would have caused tremors in the bond market. Why did long-term bonds do so well?

Jacobson: Two things. One is that it's important to remember that whatever news there is about tapering and how it affects the market is very dependent on expectations before the news comes out. If the market, for example, expects her to say that tapering is going to continue at a particular pace and has already "priced that in," then you wouldn't expect to see a big reaction.

Now, in fact when you look at the year-to-date performance, a lot of what you're seeing here actually is the result of the fact that the market and the Fed were expecting arguably a little bit more economic growth and potential inflation over the course of this year, and the latest numbers that have come out actually have illustrated that the economy is growing slower than expected. And that had a very positive effect on the long-term part of the market, because the expectations for inflation and rising long-term yields were dampened significantly as that news came out.

Benz: You mentioned that economic growth has been not that great. Why did credit-sensitive bonds do so well, or do relatively well, during the quarter? One might not expect that to be the case.

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