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Pressure Points in Your Bond Portfolio

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. With market turmoil spreading over the past few days, investors who had been flocking into fixed income over the last several months may be taking a closer look at their fixed income allocations, specifically Treasuries and their allocations to foreign bonds.

Here with me to offer some insight on those areas of the bond market is Morningstar's Eric Jacobson. He's director of fixed income analysis. Thanks for joining me, Eric.

Eric Jacobson: Glad to be with you.

Stipp: So the first question for you: On a day like today, when the markets are really suffering and we're seeing Treasuries have a lot of interest as safe-haven investments, a question for you on how investors should look at Treasuries.

We've been hearing for a long time leading up to this turmoil that Treasuries weren't going to be a good place to be because of the deficits and some of the questions around rising rates. But now everyone's going into Treasuries because there's uncertainty. How should I think about Treasuries, given these two potentially conflicting ideas out there?

Jacobson: It really does all go back to the basic premise that you mentioned, which is, are we in some sort of crisis or not? You pretty much do have to assume that whenever you have this kind of global instability, people are going to retreat to U.S. Treasuries. At least that's the way the world works today.

The other issue is that, a little bit more broadly, the fact is that the Treasury market has already priced in the expectation that yields are going to be higher in the future. Now it's very possible that as an individual investor you may not believe that the market has priced them in sufficiently, but the fact is that they are priced in. So, expectations built into the market for five years from now, for example, are that yields are going to be meaningfully higher across the entire yield curve.

If, however, you are one of the same people who believes that we are going in for a long period of economic despair, it's tough to make the case for those higher rates because as long as the system works as it does today, which is that people still rely on the United States as a refuge of safety, you can generally expect yields to remain flat or even fall potentially.

The only point at which that theoretically is likely to reverse itself is if somehow the rest of the bond market starts worrying so much about the United States that it feels comfortable hiding out somewhere else. Today, with the euro on watch, if you will, there don't really seem to be too many places like that.

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Stipp: I think it was Mohamed El-Erian said recently that a lot of the U.S. and the dollar and some of the things that folks have been retreating to is like the cleanest dirty shirt. It has its own long-term issues, but in times of crisis the Treasuries look like the best place to be.

Jacobson: Exactly.

Stipp: Second question for you, Eric, on foreign bonds. Now obviously, the Europe situation has created a lot of concern about overseas bonds. A lot of folks looked to overseas bonds for extra diversification in their portfolios. They now might be second-guessing some of those decisions, given that some foreign governments seem to be really having a crisis with their debt issues.

How should I think about my foreign allocation and making sure that if I am going to go overseas I don't get caught up in some sort of debt crisis?

Jacobson: Going back to Mohamed El-Erian as an example, PIMCO, there are certainly other firms not unlike them that have the same sort of attitude. I think it's important to step back and evaluate whether or not you're just talking about "developed markets" or the combination of developed and emerging markets.

From PIMCO and other firms' point of view, that line is a lot more blurry than it used to be. The point being that some of the best places to go may be markets that were formerly considered emerging or on the periphery.

Nowadays the big problems that you speak of are mostly in Europe, and so a fund that is very benchmark-conscious and heavily invested in Europe may be showing some of the worst pain right now.

However, funds that are a little bit more adventurous and are willing to go, for example, to Brazil or load up a lot more, for example, in Canada, Australia, countries like that where you have now what I've just described as a mix of developed and emerging. You have some flexibility there and the opportunity to avoid some of the bigger problems in some of the benchmark countries.

The second issue, though, is always going to be currency. Most of the time, people think of the diversification that they're getting in those funds as currency diversification, and while that is important, the risk of volatility is obviously there as well.

Historically, currencies have been roughly three to six times as volatile as underlying bond markets. That usually leads to the question of does it make any sense to hold a hedged fund, in other words, a foreign bond fund that has all exposure to foreign bonds but is entirely hedged back into the dollar so that you get rid of the currency risk.

The fact of the matter is if you go back and look at data there, there is still a pretty substantial diversification benefit to holding foreign bonds even if you have hedged out the currency risk.

One of the other things to think about certainly too, though, is to hand some of that flexibility off to a core manager who can still maybe put a quarter or even a third of their assets in non-U.S. bonds and let them make that decision if you don't want to make the asset allocation decision for yourself.

Stipp: Eric, do you think in some of these situations where there seem to be some pitfalls that it may make more sense then to go with active management versus trying to do some sort of indexing strategy if you're looking overseas or just in the bond market in general?

Jacobson: I think that's right, if for no other reason than you run into this problem with countries that are heavily indebted making up larger and larger portions of benchmarks, and that's true really the world over.

So having the ability to avoid a heavily indebted country that is really starting to run into trouble and everybody else seems to know it "but the index," even a modestly active manager can help you avoid some of those pitfalls.

Stipp: Eric, thanks so much for your insights and for joining us today.

Jacobson: My pleasure. Any time.

Jacobson: For Morningstar, I'm Jason Stipp. Thanks for watching.