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Bond Investing in a Teeter-Totter Economy

Christine Benz
Eric Jacobson

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

Despite concerns about potentially rising interest rates, bond funds have continued to perform well so far in 2012.

Joining me to discuss some of the recent performance trends year-to-date is Eric Jacobson; he is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: I'm glad to do it, Christine. Good to talk to you.

Benz: Eric, I'd like to start by discussing the quarter we've just closed out. It was a good quarter if you were in long-term bonds; so-so, if you were in other types of bond funds. What was going on there?

Jacobson: I think the long-term bond investors did as well as they did primarily because of what was going on in Europe, believe it or not, in the sense that there was a lot of volatility there in the political landscape, and what was going to become--what may still become--of the euro. And in those periods of uncertainty, what you tend to have, and which has continued to be the case, is people flocking to what they consider the highest quality, safest areas. So, that tends to help the Treasury market. It helped the German Treasury market as well, and it drives down yields on the long end the most, and you tend to get the best performance in those periods.

Benz: So, let's segue into year-to-date performance--that was quarter-to-date--let's talk about year-to-date. In general, I think, when you look at some of the best-performing fund categories, what you see is that risk-taking has been rewarded. Can you talk about which categories have performed best?

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Jacobson: A lot of that, as you have already sort of implied, came in the first quarter. So if you look at the emerging-markets bond category, which is at the top for the year-to-date, the category is up almost 7%, 6.95%. Most of that came during the first quarter. The category is actually off by 0.04% for the second quarter--so as you can see, just took a little bit of the edge off, but still positive for the year, based on how well it did during the first quarter.

The high-yield bond category had been a little bit more evenly distributed. It still did a lot better in the first quarter than the second, but that comes in second with a performance of about 6.7% for the year-to-date.

Benz: Eric, I'd like to talk a little bit about municipal-bond funds. It looks like they, too, have had fairly decent performance year-to-date. What have been the standout categories within the muni space?

Jacobson: Well, not surprisingly, given the risk conversation we had, the high-yield muni category has done very, very well. That one is up just about 8% for the year-to-date, and then if you go down the trail there, you start to see the longer funds doing well also. So, the muni national long-term category is up about 5% for the year-to-date, which is just about more than double the taxable-universe's U.S. Aggregate Bond Index. So, it's been a pretty good year for munis, as you implied.

Benz: Eric, when you think about some of the funds that you cover and that the team covers, some of the big, marquee-name bond funds, can you give us a little performance round up of some of the funds that have performed particularly well, or perhaps particularly poorly, within this group?

Jacobson: Well, most of the big, actively managed bond funds in the intermediate-term bond category, for example, have done pretty well this year compared to the index, certainly. As I said before, I think, the index is up about 2.4% for the year-to-date, so if you place the Vanguard Total Bond Market Index Fund, for example, in the category and look where that comes out, it's pretty far down close to the bottom. It's not quite at the bottom, but it's certainly in the bottom third. And then if you look at the large, actively managed funds, such as PIMCO Total Return for example, that fund is up about 5.75% for the year-to-date. That's in a very good spot within the category.

Other large funds, like American Funds Bond Fund of America, not quite up as much at about 3.3%, but still getting the benefit of some of those non-index bets and performing a little bit better than the index.

Some other highlights in terms of large funds, DoubleLine Total Return continues to impress quite a bit with a return of about 4.7% for the year-to-date. And then other large ones such as JPMorgan Core Bond and Dodge & Cox [Income] have done quite well. The JPMorgan fund is a little bit more like the Bond Fund of America: not screamingly better than the index, but at about 2.9%, better than the index.

And then just to round that out for a couple other big names, Dodge & Cox up 4.3%, and Metropolitan West Total Return also up about 5%.

So, the story is pretty consistent there. A lot of these funds take non-index exposures, a little bit more risk. They're doing better than the index; they're doing better than the total bond market index as well.

Benz: Eric, I want to back up a little bit. You mentioned Vanguard Total Bond Market Index, and it is such a big holding for so many people. Let's talk about what is driving its relative returns year-to-date. You noted that they're decent in absolute terms, but not so hot relative to some of these actively managed products.

Jacobson: The thing about that fund is, it doesn't have the same risk characteristics that a lot of intermediate-term bond funds are carrying today. As we've talked about before, a lot of funds in the intermediate-term bond category have supplemented their index-like holdings with things like high yield. Even if it's just a trace, it can be enough, if high yield does really well, to outperform. A number of them have added non-U.S. bonds, so either emerging markets in some cases, or non-U.S. developed markets. These kinds of things, especially when they perform well, can bump up the returns a little bit on the non-index funds.

Whereas the index fund itself is a little bit more tied--Vanguard Total Bond Market, for example--is a little bit more tied to the Treasury market, not entirely so. You certainly get help from the mortgage portfolio, and a modest slice of corporates in there as well. But you kind of split the difference in terms of how things have gone year-to-date. The fund got some performance help certainly from its corporate holdings, but for the most part, it's acting a little bit more like as interest rates have acted, and so performed a little better during the second quarter than it did in the first, but still not enough to keep up with a lot of these actively managed funds that had such better returns for the year so far.

Benz: Last question, Eric: I would like to hear your counsel to bond fund investors at this juncture. I think a lot of people are feeling still quite uneasy about what could happen with interest rates, or they may be concerned about taking on too much corporate exposure given that the economy could be slowing down. So what's your advice to investors right now, in terms of how they should think about positioning their fixed-income portfolios?

Jacobson: Well, to start off with, I'd really recommend that now is as good a time as any to stop, go back, take a look at your allocation, and see if it makes sense given your overall needs and goals.

Benz: The total allocation of bonds.

Jacobson: Exactly. And anecdotally, we worry quite a bit about this, because we've seen such huge flows into bond funds, and they've been so large that it's hard to imagine that there aren't a lot of investors out there that are more heavily skewed to bonds, for example, than perhaps they ought to be, perhaps even in some of the riskier markets as well. So I really strongly encourage people to go back and take a look: Does this make sense given the goals that I'm trying to save for, whatever they may be?

As far as down the line goes, you definitely want to take a look at those risk exposures in your bond portfolio, and ask yourself, am I heavier in some of these things than I want to be, such as high yield, such as emerging markets, things like that? In particular, they've done pretty well so far; I'm not saying that they can't do well going forward, but we're in a real sort of teeter-totter space right now, where the economy is going up and down, up and down. We don't really know where things are headed. And we've had pretty good performance already from some of these sectors. So, I'm not saying that they're overvalued necessarily, but a lot of money has flowed into them, they've performed pretty well, I wouldn't necessarily expect them to do fantastically in the future, but that is again, not steering people away.

Benz: Eric, it's always great to hear from you, great to hear your perspective. Thank you for joining us.

Jacobson: Thanks for having me, Christine.

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