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Are Rising Rates a Forecast for Storm Clouds?

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar. Bond funds notched decent gains during the first quarter of 2012, but there were some storm clouds looming on the horizon. Joining me to discuss some of the latest trends in bond-fund performance is Eric Jacobson. He is director of fixed-income research with Morningstar.

Eric, thank you so much for joining me.

Eric Jacobson: I'm happy to be with you, Christine.

Benz: Eric, during the first quarter, investors, at least toward the end of the quarter, appeared to be a little bit nervous about rising rates, and some of the most rate-sensitive bond sectors got knocked down pretty hard. What was going on there, and what were investors responding to?

Jacobson: Well, there has been a lot going on, as you know, with not only government policy but also in terms of economic indicators showing a little breath of life there. The overall numbers for last year were strong relatively speaking in terms of the Consumer Price Index. I think we're getting to the point at which there is starting to be a little bit of concern about inflation actually occurring. Well, we know it's occurring; we've seen it in gas prices. The real longer-term question is whether or not it produces some real growth.

So we've had these reasons for pessimism sort of building, including, as I said, government policy. The Federal Reserve talked a little bit in January, I believe, about what its targets were going to be going forward, and that, I think, really reset expectations. Things have just started to percolate up in the last several weeks in terms of government yields, which are starting to trickle up a little bit, if you will.

Benz: Long-term government bond funds were obviously pretty hard-hit during this period and had the worst gains among bond fund categories during the quarter. Were there any other pockets of the market that performed especially poorly due to rate-related jitters?

Jacobson: No, the government funds really took the brunt of it, and in fact the most interesting thing about the way you phrase the question is that some of the traditional areas you might have expected to do poorly, perhaps not as poorly as long-term government bonds, but namely the more rate-sensitive sectors like the municipal-bond market and even your core fund areas, have not done that poorly. In fact for the year to date even though the bonds had a rough month so far in March, the Muni National Long-Term category was actually up about 2.6% for the year to date through March 25.

That goes against a long-term government category change of about minus 5.7%. So what you've had there is a much longer story, of course, because municipals have sort of decoupled from the rest of the Treasury market ever since the financial crisis. But what we've seen is that they have started to move along with the rest of, what we call, the risk assets in a sense that when investors are seemingly more comfortable going out to more risk, they are treating municipals in that same bucket, which is not how things used to be.

Benz: So you mentioned the risk assets as having performed relatively well during the quarter. It looks like high yield had a very good quarter as well as bank-loan funds. So is that sort of the flip side of that same coin where investors are feeling perhaps a little more optimistic about the strength of the economy and a little bit more willing to take that credit risk?

Jacobson: Yes, I think it is all of those things woven together, if you will. To some degree, I think there is a question, of course, as to how comfortable people feel with risk, but they feel that they are being left with no choice because of the fact that yields are so low in Treasuries and that combined fear that they are going to tick up. They don't see a lot of value in the Treasury market necessarily regardless of what you think about whether or not rates are going to rise significantly more from here; and that is a question of some debate too. But people are feeling like whatever is going to happen there, those numbers are just too low.

So when the time looks relatively ripe and things in Europe are relatively stable and not scaring the pants off everybody, if you will, as we've seen over the last year or so, that tends to go to this what we've been calling the risk-on market trend, in which case you wind up seeing these so-called risk assets rally, such as you mentioned high yield and bank loans as well as emerging-markets bonds.

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Benz: I would like to follow up on emerging-markets bonds, Eric, because that was the best-performing category during the quarter. What were the main drivers there? Is it simply that investors were more comfortable taking risk, or is there anything else going on?

Jacobson: Well, you've got a combination of things happening there. One is simply the overall macro picture, which is that a lot of managers--including these core managers who traditionally haven't bought emerging-markets bonds--see a lot of overall value there because they believe that the fundamentals are relatively strong in a lot of these emerging markets, where the basic finances of these countries are a lot better than they ever used to be. Frankly, these markets are looking a lot better in some cases than a lot of the developed-markets governments. So that's one of the big-picture factors.

On more narrow basis, as you look around at some of them, there is some expectation in various markets that growth is actually slowing a little bit in some of those places. But when the general perception is that the rates in those countries are relatively high and still have room to come down, then slowing growth, strong fundamentals, and potentially falling rates all combine to a very attractive picture for a manager.

Benz: Now, one thing I want to follow-up on, Eric. We talked a lot about active bond-fund managers' underperformance in 2011. Have the tables turned in 2012?

Jacobson: They really have. Now, again, this is part and parcel of the question of whether or not the index being the Barclays Capital U.S. aggregate is really reflective of the universe or not. But when you go and look at how the average core fund has performed for the year to date--we'll use the intermediate term bond fund categories as a proxy there--the average fund has returned roughly 1.50% for the year to date depending on how you slice and dice thing. The index is only up about 0.18%, and when you look at the number of funds that leads in the positive column over the index, it's almost all of them with a very, very small percentage trailing the index this year.

Benz: So what were some of the key drivers that have led the active funds to outperform the index?

Jacobson: A lot of them are taking less interest-rate risk; that's one big theme that we've seen starting last year. It affected things last summer, too, when they didn't do as well. Now, they are benefiting from that as we've had this little yield spike happen in last several weeks.

The other thing is they are taking on more, what we were calling, risk assets. Now, I don't want to scare anybody by overplaying the point because when you look at a lot of the largest funds, we're not talking about 30% or 40% allocations. But you're finding enough allocated in terms of high yield, emerging markets, things like commercial mortgage-backed securities, asset-backed securities, and even some municipals depending upon the fund that you're looking at. You're finding that those things sprinkled around the edges, combined with a little bit less interest-rate sensitivity, means that a lot of those funds are doing better this year than the index.

Benz: Eric, last question for you, and I know it's a difficult one, but a lot of investors are looking at this recent yield spike and thinking, "Is this the start of something really bad?" What's your advice to investors who are checking out their portfolios at this juncture and maybe are worried that they have a lot of interest-rate exposure in their portfolio currently?

Jacobson: Of course, as you suggest, that is sort of the $64,000 question. I don't know the answer to it, and I think almost anybody who tells you that they do is being a little overconfident because we just don't know where things are going right now. You've got a lot of cross currents in the market between the Fed doing what it's doing and the economy is still not being at the point where we know exactly how strong it's going to get.

But what I would say in direct answer to your question is, take a look at your funds' underlying features. Obviously this is not new advice for us, but it's important, nonetheless. Even if you had owned funds that in the past were taking considerable interest-rate risk, they may not be taking it right now. We're seeing that across that board almost in the core bond space where all the intermediate-term bond funds tend to congregate. Most of them, as I suggested, are taking less interest-rate risk. They are buying many fewer Treasuries, and they are supplanting them with other parts of the marketplace that are generally not as sensitive to rising yields. We're seeing that play out right now in funds' behaviors. So dig down and look in those portfolios first before you start making big changes.

Benz: Eric, thank you it's always terrific to get your insight. I know that our readers are very interested in fixed income and concerned about what they perceive to be storm clouds gathering. So, we very much appreciate your advice and your insights. Thanks for joining us.

Jacobson: I'm glad to be here Christine. Thanks.

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