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Recent Bond Bumpiness: More Than Just a Hiccup?

Christine Benz

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

After performing quite well for the better part of this year, the bond market has recently come under pressure. Here to discuss what's been going on with bonds and whether this is a precursor of things to come is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thanks so much for being here.

Eric Jacobson: Glad to be with you.

Benz: So, let's talk about what's going on in the bond market. What is putting pressure on bonds currently in your view?

Jacobson: There are really a handful of things, and it's sometimes difficult to sort out what's affecting which part of the market. I think that some of the response to the latest tax bill that's been going through has sort of reinvigorated the discussion around whether or not rates need to be higher. We've also had the effect, which is double-edged, in terms of the ongoing Fed policy, enactment of what they call QE2, quantitative easing.

So there is some kind of crosscurrents in there, because on the one hand you've got the Fed buying up bonds that in some ways is expected to have a depressive effect on rates and upward pressure on prices.

On the other hand, you've got the positive effect of the action itself, which is what's intended, which is a revaluation of where growth is in the economy.

So it is sort of hard to ferret out, what's the positive, what's the negative. But by and large, when you add the tax legislation and the effects of the quantitative easing, if you will, I think by and large, investors are reassessing what the growth possibilities are in a positive way right now at least in the short term.

Benz: So when you talk about the tax package having an effect here, the concern at least in the bond market, appears to be that it might be overly stimulative or that it would drive inflation perhaps?

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Jacobson: I think that by and large, Wall Street is a little less panicky about it than the folks on Main Street are in some ways. But yes. Anyway you slice it, rates have been relatively low. So, in some ways, you can look at it as sort of a repricing in the sense that, okay the market is taking this into account, and they are going up a little bit, but so far we haven't seen signs of the runaway rising rates that people have been fearful of.

Benz: So when you look at the bond market and pockets of the bond market that have been hardest hit amid this recent turmoil, which are the areas that have dropped the most?

Jacobson: Well, the longest maturity ...

Benz: ..Which you'd expect right?

Jacobson: Yes, which makes a lot of sense. And I think it's important for people to remember, too, that depending on what kind of funds they are in, they may not be as heavily exposed to that as you might have imagined, historically, in part, because managers have been much more focused on the 10-year in the last several years. And frankly a lot of intermediate core bond funds have been staying away from the more volatile interest rate sensitive sectors in the last several months.

Benz: ...Because a lot of people anticipated that maybe there would be some impact…

Jacobson: I think partly they anticipated and partly, if you are just looking for value in general, whether managers have expected rates to rise or not--and frankly, contrary to popular belief, this isn't the game that most of them play; they don't sit down worrying, "is the 10-year going to shoot up 30 basis points next week." But what they do do is say, well, "it just hasn't been yielding enough, and it's just not offering enough value for the risk, and so we're going to try to find something else that does."
And up until now, a lot of them have been focused on various other sectors.

Benz: So, let's talk about, amid this recent drop in the bond market, what has held up relatively well?

Jacobson: Actually, depending on how you're looking at it, in the last few weeks, it has actually been kind of rough because I think when you take into account some of the other things going on in terms of Europe and the crisis there, and you also look at what's been going on with the Build America Bonds legislation, which has caused some concern about whether or not that program is going to be renewed. You've actually had sell-off in high yield as well to some degree, which a lot of people wouldn't have expected necessarily. So, lately, things haven't been real good pretty much across the board. There are just some pockets where they just haven't sold off as badly as the 30-year Treasury, for example.

Benz: But almost everything has at least a small loss over the past month when you look at the fund categories.

So Eric, I think the big question for investors right now is, is this a precursor of what you might expect from bonds in the future? I've talked to a lot of investors, and they are really concerned about their fixed-income allocation, and I think they are rightfully wondering, are all the asset allocation models that prescribe X much in bonds looking at the past couple of decades, which has been a very benign environment for fixed income. What's your take on that question?

Jacobson: I think that there is certainly a possibility of that especially when you are looking at models that are based on historical data. On the other hand, it's still always comes back down to risk tolerance, I think, and whether or not what you saving for, what you are investing for, has goals associated with it and can tolerate the kind of volatility that you would be taking on by making a big shift, say for example, into equities.

I think one of the things it's worth reminding people is to go back and look at what happened to your portfolio in 2008. But look at it a little more carefully and ask yourself what would happen if I, for example, made a big shift out of fixed income and was completely into equities or much more so than now, and how much volatility can I tolerate?

The fact of matter is, when you go back there, even in the worst days of crisis, fixed income market still held up much better than the equity markets, by and large. Now, I'm not saying that people should be slavish about sticking around in the most core, most interest rates-sensitive areas necessarily, or areas that don't appear to have any value, but then again most people's managers are taking that into account as well.

I mean, if you're an owner of any of the big popular core bond funds, chances are you've got a higher allocation to more yield-rich sectors that your managers think are going to hold up better if we have a sustained rising rates, which by the way, most of them are not expecting right away still anyway.

So, you want to take a look at that as well. But I would say overall it's always a good idea to step back and see if the valuations makes sense, and ask yourself if you want to tilt things a little bit. But try to remember that even with bonds having relatively low interest rates right now, overall you're still going to have less danger of big volatility than you will with a real stock-heavy portfolio.

Benz: So Eric, you touched on this disconnect between Main Street and Wall Street and what managers you are talking to are expecting the rate environment to be like. Can you address that question? Are they anticipating big interest rate increases in the near future?

Jacobson: Let me say this: It's not that they have their heads in the sand and Main Street is wild-eyed, wide-open. I think that there's a perception of that to some degree. What it is, though, rather I think is that managers are asking themselves, what are the catalysts that will eventually start driving interest rates up and when are they likely to occur?

So for right now, for example, there's very really little expectation that the Fed is going to move anytime in the next year. So that's one thing. You just don't see any pressure on short-term rates. You also have the Fed in the market still with QE2 buying up bonds. You can't really shrug that off. It's a big effect, especially when they're buying perhaps $75 billion a month or what have you.

The other issue is that the fundamentals are still relatively, again, on a relative basis, are relatively weak. When you have the level of unemployment that we still have and persists, and we're still talking about relatively small shots in the arm in terms of the stimulus that we're seeing, there isn't a lot of underlying fundamental growth and inflation threat there to drive rates higher.

At the same time, you've still got a situation where it's in the best interest of China, for example, this is something people often talk about, to continue selling their goods to us at affordable prices and buying up assets, which are usually Treasuries or mortgages for example, to keep the currency where they want to keep it. Those are all factors that lean in favor of not seeing a big spike in interest rates anytime soon. It doesn't mean it can't happen. It doesn't mean it won't happen occasionally, but I think if people are concerned about this runaway rising rate spike – again I am not saying it can't happen – but it's relatively unlikely with these depressive impacts, if you will, from all these other levers.

Again one other issue that ties again back to China that people aren't really looking at that often is the dollar still remains what the world considers its reserve currency. And that makes a big difference, and that gives us a big advantage in this situation. Not that we wish any ill-will on Europe, but to the degree that things are still disorganized over there and we still have trouble in the European sovereign markets and their banking crisis and so forth, it doesn't seem likely anytime soon the rest of the world is going to switch away from the dollar.

If we had a point where the dollar becomes less desirable, even more so than today, if you will, as a place to store your money globally, then we're at a much bigger risk. That's where the money printing stuff that we're talking about becomes even more dangerous, because if the world chooses to start dumping dollars at some point, yes, we absolutely could see some poor effects from that. It just doesn't seem right now that we're in an immediate, imminent danger.

I think again back to the Wall Street versus Main Street thing, I think most managers, they believe that rates have been up until now a little bit too low, especially on Treasuries, especially given the stimulus that's been coming up. So they're worried about it in some cases depending on which parts of the yield curve, but I haven't heard very many of them spend a lot of time worrying that we're in store for some runaway rising rate experience at this point.

Benz: Eric, thank you. That's very helpful context. We appreciate you sharing it with us.

Jacobson: Glad to be with you.

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