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Risk-Taking Pays Off for Bond Investors in 2012

Christine Benz
Miriam Sjoblom, CFA

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

As the year winds down, it's clear that risk-taking has paid off for bond fund investors so far in 2012. Joining me to share some perspective on bond fund performance so far this year is Miriam Sjoblom. She is associate director of fund analysis for Morningstar.

Miriam, thank you so much for being here.

Miriam Sjoblom: Good to be with you, Christine.

Benz: Miriam, you noted in a recent commentary that everything risky appealed to bond investors in 2012. Let's talk about some of those key categories that have actually performed very well and gathered a lot of investor dollars?

Sjoblom: That's right. Some of the best-performing sectors this year have been high-yield corporate bonds and emerging-markets debt. Non-agency mortgages--we don't have a lot of funds that invests heavily in those--but that has also been a very strong-performing sector this year.

So you are talking about returns in a range from 15% to 20% for some of these sectors, and at the same time you see that sort of grab for yield; investors have been attracted to the extra yield offered by high-yield corporates and emerging markets, and the great returns too. Those two categories appear to be on track to receive record net inflows this year in excess of $20 billion.

Benz: But Miriam, the core funds also did really well. So it wasn't just the higher-risk categories; you also did well if you were in a core type intermediate-term bond fund?

Sjoblom: That's right. And a lot of core funds do invest a little bit in these types of sectors--high-yield and EM--and currency was also big, if you had a little bit of currency exposure.

Benz: If you didn't just stick with the dollar, but invested in foreign currency denominated bonds.

Sjoblom: Yes, especially some emerging-market currencies, Eastern Europe and Latin America, then you did pretty well.

So, this was a year where, if you were just in the plain-vanilla index, you did well. You got about a 4% return to be in a Barclays U.S. Aggregate Bond index-tracking fund. But we had some active managers who were more adventurous, returned in excess of 10%, and lot of big widely followed managers like Bill Gross, who had a difficult year last year at PIMCO Total Return, and this year, he is doing really well, partly from having exposure to some of these areas.

MetWest Total Return Bond is also having a great year. They made good bets in financial corporates, which had a big rally this year. And non-agency mortgages, they've owned a teens-size stake in that sector, so they did very well owning those types of securities, too.

Benz: You also mentioned that another widely held fund, Templeton Global Bond, had a reversal of fortune--not such a great year in 2011, a very strong year in 2012. What was the underpinning of its success?

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Sjoblom: That's right. So it was the year of a bounce-back for some big managers, and that fund is doing very well, up close to 15% this year, and really it didn't change any of the portfolio other than to, when certain currencies and securities would sell-off, manager Michael Hasenstab would add back to them. So really kind of keeping the same position year-to-year, the fund has just really benefited from a bounce-back mainly in its currency positions--a lot of those currencies I mentioned--Asia, Latin America--and also he's had a longstanding short to the Japanese yen, and that's something that started to work this year as well.

Benz: Now Miriam, I know you spend a lot of time focusing on municipal-bond funds. I'd like to talk about whether the trends have been similar there. Have you also seen risk-taking being rewarded within that space?

Sjoblom: It's always, I think, a little bit concerning when you see investors taking a lot of risk in the muni universe. Because I think a lot of investors see munis as their kind of safe, reliable, dependable income stream. But we've seen record levels of inflows into high-yield muni funds this year. The rewards have been really fantastic for muni funds.

For high-yield muni funds, you've seen a range of returns in the 10% to 20% range this year, and that goes according to risk taking. So if you're taking more interest rate risk, more leverage, more credit risk, you got a higher return this year.

Long-term muni funds have also performed very well. Returns in the 7% to 10% range have been pretty common.

Benz: I'd like to take a look forward and get your thoughts on what bond fund investors should be thinking of as they think about the years ahead. We've seen these torrential asset inflows into bond funds, as you note, into some of these riskier categories. So I'd like to get your take on what bond fund investors' expectations should be as they think about not just 2013, but also the years ahead for bonds?

Sjoblom: Well, even just looking at core funds, intermediate-term bond funds have just gotten a huge amount of flows, and it seems to show no signs of slowing. And you are looking at a yield right now on the Barclays Aggregate Bond Index of about 1.8%, and that just tells you, from an income standpoint, there are very low returns to be made out there, and also for you to make capital gains in the bond market, you have to see yields drop even further. And so at 1.8%, you can imagine yields could go a little lower from here, but they are not going to go that much lower. So, there is really not a ton of return to be made out there.

So, you should start to look at, what are the risks out there, too. Yields could certainly go higher, and we are not going to predict when yields are eventually going to rise, but you can start doing the calculations in your head and saying, … my portfolio is producing very little income to offset potential losses from a rate rise, and so I think investors really need to prepare themselves for the possibility of experiencing losses, or at least leaner returns going forward, and [consider] the possibility of what could you withstand in terms of losses in your bond portfolio?

Benz: Just to play devil's advocate, it seems like there has been a lot of pessimism about bonds and bond funds for a couple of years now. I think probably coming into 2012, people were saying something similar that yields aren't great. Where does the math add up for bond fund returns? And yet, returns were quite good this past year. You think, though, that there just isn't much cause for optimism now.

Sjoblom: Well, a lot of those returns came from those sectors, like high-yield corporates, that we talked about earlier, and investment-grade corporates also did very well. And that's mostly due to a rally for financials, which had a really rough late 2011.

So coming into 2012, there were lot of sectors that many portfolio managers thought looked cheap relative to historic norms, and high-yield would've been one, financial corporates would've been one. But now, after this year's rally, what we're hearing is that a lot of these sectors are priced at their average. So that's not cheap; that's just average. Sure they could continue to do well, and we saw that in years past where you can do better from a level of average cheapness.

But … the managers we talk to are saying that it's really becoming harder and harder to find somewhere to put our money to work. So we're seeing and hearing managers tell us about the defensive moves that they are putting into their portfolios, they are taking some of that risk, that credit risk, down and shoring up the portfolios to some extent. I think that should be cue to investors who continue to pile money into funds that the opportunities are not what they have been in the past.

Benz: OK, Miriam, thank you for providing this very valuable perspective.

Sjoblom: You are welcome, Christine.

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