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By Christine Benz and Sarah Bush | 10-01-2014 04:00 PM

A Tricky Third Quarter for Bond Funds

Despite strong fundamentals, credit-sensitive bond funds lagged last quarter, while longer-duration funds defied conventional wisdom.

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

Bonds had a tricky third quarter, but many bond funds are still well into positive territory so far this year. Joining me to recap the latest performance action is Sarah Bush, a senior analyst with Morningstar's manager research group.

Sarah, thank you so much for being here.

Sarah Bush: Thanks, Christine. I'm glad to be here.

Benz: Sarah, let's start by talking about the third quarter. It was mainly a tricky quarter if you owned credit-sensitive bonds. Why were investors generally dumping them during the quarter?

Bush: That's an interesting question. Credit has been a great place to be for almost the entire period since 2009; you've got equity-like returns in high-yield funds. But the third quarter was tough, as you mentioned. We saw pretty big outflows from high-yield funds in July and August and then saw some pretty negative returns in September for these funds.

In terms of what's driving it, it's a little harder to figure out. All the managers we talk to say that fundamentals still remain relatively strong. It's definitely been a borrower-friendly market, but they're not seeing huge run-ups in leverage ratios, and they don't have real concern about quality or an increase in the default rate.

So, it does seem to be driven maybe a little bit more by technical factors and fund flows. High-yield is also sensitive to rumors of geopolitical risk. Anything that makes people concerned about risk can be a problem.

Benz: So credit-sensitive bonds were undergoing a little bit of a reversal in the third quarter. Let's step back and look at where we have been year-to-date. I think the interesting thing, Sarah, is that coming into this year, very few people would have expected to see long-duration bonds perform as well as they have. What's been driving that trend?

Bush: We saw a very strong consensus view coming into the year that this was definitely going to be a year where rates continue to increase, and in fact the yield on the 10-year Treasury is way down today from where it was in January. It was a call that very few managers got right. Jeffrey Gundlach at DoubleLine funds prominently got it right, but a lot of managers really thought that we were going to be in this environment where you wanted to be short duration.

In terms of what's been driving that--a couple of things. We've had some mixed news on the economy. The longer part of the yield curve--10-year bonds going out--really does tend to be more sensitive to geopolitical risks. So some of what's been going on with Europe and in the Middle East can also have an effect on that part of the yield curve.

Benz: One other bit of conventional wisdom that has been very much out there for the past few years is that the Barclays Aggregate Index is going to be a very easy benchmark to beat. That has not necessarily been the case so far this year for intermediate-term bond fund managers.

Bush: That's right. If you look at where the Agg is year-to-date and where the median or average intermediate-term bond fund, it's right on top of there. So it really has been a lot harder. I think some of that was because of people's expectations about interest rate risk.

Benz: When you look at some of the big prominent funds that you and the team cover, let's talk about some of those that have really been leaning the right way when you look at their 2014 performance so far.

Bush: One fund that has done particularly well year-to-date is Western Asset Core Plus. That's a fund where a non-agency stake was certainly a positive through the first half of the year, and they also have at times in the year actually leaned a little bit long in terms of duration, so that's been a positive for the fund.

Another fund that's done relatively well--and this was a nominee last year for our U.S. Fixed Income Manager of the Year--is Dodge & Cox Income. They've done pretty well this year, and that's interesting because they have been conservative on interest rate risks for a while now, and that was a positive in 2013. But they leaned a little longer within that positioning at the beginning of the year, and they've also had some wins on the security selection side, especially outside of the United States.

Benz: I don't want to make the whole segment about PIMCO. I think that there has been plenty of PIMCO news out there. But let's just quickly talk about the big Total Return Fund. It is kind of having a year to forget so far in 2014.

Bush: Right. It's definitely lagging the benchmark by a meaningful margin and lagging a good percentage of its peers, and it's something we're watching very closely, especially with concerns about outflows from PIMCO with the news about Bill Gross a couple of day ago.

Benz: We've been talking about taxable-bond funds, but let's take a look at what's been going on in munis; that's been an area that has had surprisingly strong performance. Is it just that munis were pretty beaten down in late 2013, so maybe they had some room to move up?

Bush: Right. Munis really did have a rough time--even rougher than taxable funds--in 2013.

Benz: What was driving that?

Bush: I think a couple of things. We had some really big headline risk…

Benz: Detroit.

Bush: Detroit is the obvious one. Puerto Rico is another one. And Puerto Rico was a big holding in a lot of funds even with a relatively high-quality focus. So even though those stories are still out there and still something that people are paying attention to, I think that overall the technical flows into that category of funds have increased and been positive this year. And then also just, the general picture for municipalities, if you were to step away from those headline stories that get so much attention, has been a positive and improving one.

Benz: And I know that a lot of the issuance in the muni market is also long duration, so I assume that has potentially helped some of the funds, too?

Bush: That's also a positive, as it's been a good year to be a little bit further out on the curve.

Benz: Sarah, thank you for being here. It's always great to hear your insights.

Bush: Thanks very much for having me, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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