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Where Bond Investors Pulled and Placed Their Bets

Christine Benz

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

After favoring bonds for the better part of two years, investors retreated from the asset class in 2010's waning days.

Here to add some color on what we're seeing in terms of mutual funds' inflows and outflows is Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thanks so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So, Kevin, it was a really strange close to the year in that we saw dramatic outflows from bond funds. Can you talk about where investors seem to be subtracting the most money, and what they were responding to?

McDevitt: Sure. The most dramatic outflows were in municipal bond funds. We saw outflows of nearly $14 billion last month alone, and that's on top of about $7 billion the previous month. So, that's $20 billion in two months, and that's about 4.5% of overall assets. So, that's a huge reversal from the previous year.

Benz: So, investors might have been looking at a couple of things. I think the initial headline was, "Oh, they are worried about what's going on at state and local municipalities." But, it seems like maybe there were some other things in the mix as well.

McDevitt: Sure. I think, right, there was a lot of headline risk you had. You had the 60 Minutes piece with Meredith Whitney. And you also had just general headline risk with what's happening with municipalities, as you said.

You also had some other factors, too; you had the extension of the tax cuts, which I think perhaps you had investors buying these funds thinking they want to have some income protection, but that ended up not being really a good basis anymore.

Benz: So, if people thought tax rates were going to go up, munis would be a good place to be, but then there was a sell-off when it didn't appear that taxes were going up?

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McDevitt: Exactly. You also had the end of the Build America Bond program, which have been a source of purchasing power in the market. When that program ends, you took away a pool of buyers there.

Benz: Okay. Also interest rate shocks, right, and that affected all bonds, not just munis?

McDevitt: Absolutely. You had interest rates going up in early October. They went up pretty much through mid-December. You had the 10-year Treasury go up four percentage point in two months, which is a pretty big spike in a short amount of time. You saw the biggest hit were the most interest rate sensitive funds, especially amongst intermediate-term government funds.

We also saw a hit in some other areas, too: world bond funds took a hit to some extent. But the biggest hit by far in terms of returns was municipal bond funds, where you had both the interest rate impact, but also just selling pressure. Individual investors are a huge part of the municipal bond market. So, when they sell, you really do see the impact on returns.

Benz: Right. So, was it a wholesale retreat from bonds or were there a couple of categories where investors appear to be staying put or even adding money?

McDevitt: It's interesting. We saw a lot of interest still with the credit categories, like bank-loan funds had nearly $4 billion in inflows last month, which for that category is a record. With those funds, they're not getting hit as much; they are not getting hurt by rising interest rates. They actually benefit to some extent. So that category still had inflows; you still have inflows in emerging-market bond funds, high-yield bond funds, and to a lesser extent world-bond funds, too.

Benz: So it seems like with some of those categories, you have to wonder if it's a little bit mixed up with performance-chasing because performances has been pretty good in some of those groups, too?

McDevitt: It has been, and it's somewhat of a concern. You've seen a lot of money flowing into emerging-market funds, as we've discussed in the past. That's both on the emerging-market bond side and on the emerging-market equity side. With bank-loan funds, too, that's a bit of concern. We've had very strong returns. But there's a lot of credit risk there, too, so we want investors to be aware of that.

Benz: Right. So it appears that investors are saying, "Well, I'm not so nervous about the credit risk right now, more concerned about the interest rate related risk?

McDevitt: Right. You start to see a change in the flow pattern in September of '09, and up to that point, you saw a lot of money flowing into short-term and intermediate-term bond funds, and it really just turned around last few months. You've seen investors again, more embracing credit risk and fleeing to some extent interest rate risk. But just because returns have been strong in these credit markets doesn't mean investors be complacent about the possible risks there.

Benz: So, Kevin, let's talk about what you're seeing in the equity fund flows: inflows, outflows. What's going on with those categories?

McDevitt: Sure. You still are seeing outflows amongst U.S. domestic stock funds, and especially with the large-cap sector of the market. Large value, large growth are still seeing heavy outflows.

The only thing you can say is that the pace has slowed a bit in the last three or four months. There is not as much money leaving those funds. If you are seeing inflows, most of that money is going into small-cap and mid-cap funds, and this isn't terribly pricing given that small- and mid-cap funds had another great year in 2010. The concern, though, was again that there is perhaps an element of performance chasing here.

Benz: Right. I think that's a question I always have for you. How much should you look at these figures and say, "A ha! There is a contrarian signal. Maybe small and mid-caps are not the place to be if other investors are really glomming onto them right now."

McDevitt: Well, I think you certainly want to wary. In terms of how sharp of a signal those flows are, it is difficult to say. To be honest, we've been seeing this trend with small caps for a long time. Coming into 2010, they had already outperformed for about a decade. So that premium, perhaps, that's being attached to small- and mid-cap stocks, small- and mid-cap funds, has been there for a while. I'm not sure when it will turn. That said, though, it's hard to argue that small- or mid-cap stocks are cheap relative to large caps.

Benz: Yes, and you mentioned to me that the gulf between small-cap value and large-cap value in terms of returns in 2010 was one of the widest you'd ever seen?

McDevitt: Yes. It's one of the biggest we've seen in about a decade. Again, small-value stocks, small-value funds had a great year in 2010; large-value funds did OK, but not nearly as well: I think the average return was 7%-plus or so. So, nothing in the long lines of 25% to 27% you saw with small- and mid-cap funds.

Benz: Kevin, I want to discuss this ongoing trend we've seen toward passive investments. Is that a trend that you've seen persist into the year's fourth quarter?

McDevitt: Yes, absolutely. If there are any inflows, they are into passive index funds for the most part. You're seeing this on the ETF side as well. You are seeing positive inflows into U.S. equity ETFs, too. So, again, there is that kind of divide between actively managed stock funds and passively managed stock funds. That said, I think the trend is not quite as strong as what had been earlier in the year.

Benz: I want to touch on fund families, and who have been the biggest beneficiaries and who have been the biggest losers in some of this market action, and outflow and inflow action. What's your take on that question?

McDevitt: Well, the biggest beneficiary, one of the biggest beneficiaries by far is PIMCO. Any shop that has, as PIMCO does, any shop that has a lot of bond funds has really benefited in general, even though we've seen a bit of reversal here in the last few months.

PIMCO, BlackRock, Franklin Templeton, families that have a lot of bond funds have benefited the most from this environment. Those families that are very equity-oriented, like American Funds, for example, and Fidelity to a lesser extent, have suffered the most in terms of outflows.

Benz: I know you mentioned Franklin Templeton was an interesting one. It's always one of the biggest fund shops, but you mentioned that as one where it was very individual-fund specific. Big inflows, but it's mainly going into one fund.

McDevitt: Sure. Yeah, the big beneficiary has been Templeton Global Bond, which is managed by Michael Hasenstab, our 2010 Manager of the Year. And that fund has just gotten a tremendous amount of inflows and to some extent has carried Franklin Templeton, not entirely, I don't want to take that too far, because they still have seen inflows into some of their other fixed-income funds. But that fund sticks out as being the flagship for that family.

Benz: Well, thanks, Kevin. Thanks as always for sharing you insights.

McDevitt: Thanks for having me.

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