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By Christine Benz and Sarah Bush | 04-02-2015 11:00 AM

Bond Market Continues to Surprise Naysayers

Long-duration bonds got a boost as yields unexpectedly dropped in the first quarter, but foreign currency exposure dragged on some global-minded funds.

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

The bond market continued to surprise naysayers in the first quarter of 2015. Joining me to provide some color on bond fund performance is Sarah Bush, a senior analyst with Morningstar.

Sarah, thank you so much for being here.

Sarah Bush: Thanks for having me, Christine.

Benz: Sarah, let's discuss what happened with interest rates in the first quarter. I don't think people were expecting yields to drop lower, but we actually saw a pretty good move downward in terms of 10-year Treasury yields, and that provided a boost to bond funds.

Bush: It's very interesting, because the big story that everyone is focused on this year is the Fed raising rates, and we'll talk about that later. Actually what we saw--and it's important to distinguish what rates we're talking about--but we saw further out the curve, a very nice rally in 10-year Treasury coming into the year. A little bit of backup in February. It's bounced around since then, but it's still looking strong year to date.

Benz: That provided a boost to bond funds. Let's talk about the Fed action. This is the big question. All bond market participants have their eyes on what the Fed will do and when it will do it. What's your sense of what that will mean for bond funds?

Bush: That's the million dollar question. Everyone is paying very close to attention to every word the Fed says about when and how it might raise rates. A lot of people thought coming into the year that we might have been looking at a June time frame for raising rates. Now maybe the Fed is looking at September or later. There is a fair amount of uncertainty, and that uncertainty, to the extent that the Fed acts earlier than market participants are expecting, could be disruptive.

The other dynamic at play here is that we've been at a zero interest rate policy for so long, there is a question that, as the Fed starts to move, what impact does that have on broader markets? Everybody is paying close attention to that.

Benz: Also I think people wonder about the velocity of rate increases. Once the Fed begins to take action, will it act pretty aggressively to move up rates? What's your take on that question?

Bush: Most of what we're hearing is that it's likely to be slow, and the Fed is clearly paying a lot of attention to what's happening in the economy, what's happening globally, what's happening with inflation expectations, what's happening with job growth. They'll be watching that very carefully, and I think everyone would be surprised if we saw a big, fast move in changing rates.

Benz: When you look across bond fund performance, you say that the first quarter was kind of a "risk-on" quarter. Long-duration bonds, as you discussed, had a good period. But also high-yield bonds. Let's talk about long duration first, and which fund types tended to benefit from that move downward in rates.

Bush: It's unusual to see a rally in the long duration Treasuries and high yield. A lot of times those two move out of sync with each other.

In terms of getting that interest-rate bet right, that was clearly a challenge for a lot of fund managers. Last year, in 2014, a lot of managers came into the year short. I think there were more managers that were neutral to a little bit long this year. Western Asset, which was our 2014 Fixed-Income Manager of the Year, the team there came into this year with a relatively long duration, which has been a positive for their strategies.

Benz: Let's talk about lower-quality bonds. High-yield funds had a pretty good quarter. But there is a bifurcation there with the energy sector in the mix.

Bush: High yield had a really rough 2014. We've seen a bounce-back year to date in the high-yield market. However,  as you suggested, energy prices are still volatile. There is still a fair amount of uncertainly about the direction they're headed. So, a lot of energy names are still trading at distressed levels. We ask managers, "Is this a screaming buy?" and there is a lot of concern that there could still be a lot of pain in that sector.

Benz: You also point to the mortgage sector as an area of interest in the first quarter. What went on there? That sector came under some pressure. Why was that?

Bush: The Fed had been so involved in actively buying new mortgage production, and new investments there ended last year; the Fed is still reinvesting to the extent that they're getting payments back. So the Fed has stepped back a bit from that market, and it was a market that a lot of fund managers thought was richly valued. It underperformed pretty dramatically in January and is a laggard year to date.

The other thing that's going on with mortgages is that when you get a big rally in rates, there is more of an incentive for people to refinance, which is not good for the mortgage sector. All this volatility can be rough on mortgages. It's been interesting, because mortgages have been a really solid performer in previous years.

Benz: Ginnie Mae funds, in particular, are under some pressure.

Bush: Ginnie Mae funds are really having a rough stretch, and again this is a sector that had been performing very strongly.

Benz: Most people know that the dollar has appreciated versus major foreign currencies. Let's talk about how that shakes out and has affected some funds' performance.

Bush: The immediate place you see it is in some of the foreign and global bond categories. So, hedged funds are doing relatively well; funds with lots of foreign currency exposure are having a much rougher time.

But foreign currency also plays a role in some other, more broad-based portfolios. PIMCO Total Return, for example, has been on the right side of that trade. They've had a short against the euro and the yen for a while now, and especially that euro short has been additive year to date.

Templeton Global Bond is a little above flat year to date,  but they're doing well relative to their peer group, again, because of a euro short.

On the other side of the table, however, are funds that have been more active in taking on [currency] exposure. Loomis Sayles Bond and some of their other strategies fall in this category, and they've had a rougher time year to date as we've seen that pressure and the strength of the dollar.

Benz: Sarah, it was a surprisingly good quarter for bond market participants. Thank you so much for being here to share your insights.

Bush: Thanks for having me, Christine.

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

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