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Will Investors Hit the Credit Brake Anytime Soon?

Christine Benz
Eric Jacobson

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With fund flows continuing into bond funds so far in 2013, we decided to take a closer look at some of the specific funds that investors have been buying. Joining me to discuss that topic is Eric Jacobson; he is a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Great to be with you, Christine. How are you?

Benz: Good. Thanks, Eric. So let's get right into this list. I'm wondering if you can kind of generalize when you look at some of these biggest asset gatherers year to date, we've got PIMCO Total Return, DoubleLine Total Return, MetWest, when you look at some of the biggest asset gatherers, what sort of themes do you see emerge?

Jacobson: Well, on the one hand, it's interesting because they're not niche funds per se. Not everyone on the list, but those that you mentioned, in particular, are real core-focused bond funds. They tend to be very popular with investors for that central part of the portfolio. None of them is completely skewed in such a way--they are not high-yield funds, for example, and they are not all-foreign or what have you. So, that's one interesting thing.

The other interesting thing about them is that most of them are not managing very closely to the commonly used benchmark, the Barclays U.S. Aggregate Bond Index, over the last couple of years. They're taking on essentially less interest-rate risk and more credit risk.

Benz: I know it's hard to generalize about what investors, in general, are thinking when they're buying specific funds, but when you look at this particular crop, this more generalist group of funds, would you say that maybe investors are a little uncertain about what's next for the bond market and so they want to delegate to managers who have some flexibility to range across different sectors and so forth?

Jacobson: I think that's part of it. I think we are seeing a few different streams of interest in terms of what investors are doing. One of them is this delegate to your manager. In some cases, as you mentioned, you've got it in these big, well-known core funds, like PIMCO Total Return.

In other cases, even not necessarily in the top five, but a little farther down on the list, you've got PIMCO's Unconstrained Bond fund, for example, which still had very strong flows last year, as have some of its closer competitors, which are funds that really have that go-anywhere mandate and not just in terms of the sectors, but also in terms of keeping their interest-rate sensitivity, not only very, very short but sometimes even a little bit negative.

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Benz: Well, that's another point I wanted to follow up with you on, Eric. We don't see any long-duration funds in this group. In fact, if there's a bias here, it is toward some of the short-duration products. And one fund, in particular, that maybe isn't usually on this list of biggest asset gatherers is this Lord Abbett Short Duration fund. I'm wondering if you can talk a little bit about it and overall that tendency of investors to be shying away from some of the longer-duration products?

Jacobson: Sure. That's sort of a perfect textbook example because that actually has become a quite a large fund, and pretty clearly it's because it's very low and short in duration as you suggest, and it also takes on a considerable amount of credit risk relative to other funds of its type.

So it's going to be attractive to investors because it boasts a fairly high yield, given the category that's in. At the same time, it's in a category that is very appealing to people right now because they are very nervous about the possible effect that rising interest rates would have on the bond market.

Benz: Another fund that we have not typically seen in this list of top asset gatherers is PIMCO Income. And I'm wondering, if you can talk about that fund and talk about how it's different from that core Total Return product, which has been for a while now one of the fund world's biggest asset gatherers?

Jacobson: Sure. PIMCO Income is one of those big hot names that's really taken a hold of the market in the last year or two, and, let me just say, pretty clearly one of the reasons that it's hot is because of that "Income" word. It has one of the highest yields of any fund out there and actually uses a little bit of leverage. It does so, as you suggest, in ways that are pretty different from your typical core portfolio. It holds a lot of nonagency mortgages and has a considerable slice in emerging-markets debt, as well.

It's meant to be a stable income provider; that was sort of the original goal the fund, to payout a very even-keel distribution and not let that distribution get threatened. But in addition to pumping out that predictable level of income, it's also a very high income payer, and the returns have really been solid.

Clearly there are some risks factors there. The good news is that PIMCO and the manager, a fellow by the name of Dan Ivascyn, have a record of doing well when things turn sour. But that's no guarantee. This is a much more risky portfolio than most of the other core portfolio offerings out there that people think of, such as PIMCO Total Return, for example.

Benz: Now I see that we've got a lot of active management on this list, but there are a handful of index funds represented here. Let's talk about where the flows have been going to the extent that investors have been buying index products; they have been buying total bond market index funds. What other types of index products are they looking at?

Jacobson: I think the most interesting, most telling one, as you suggest is the iShares iBoxx Investment Grade Corporate Bond index because that is indicative of this general behavior to go toward corporate bond markets where there is extra income to be had. And if you go down the list of categories, you see sort of the same thing in terms of where investors have put money over the last year. A lot of it has gone to not only the short-term and the shorter-duration intermediate-term bond funds, but emerging markets, high yield, bank loans, multisector, et cetera.

Benz: One other niche product, and there aren't many on this list, as you noted, Eric, is the Templeton Global Bond, which is continuing to get very solid flows so far in 2013.

Jacobson: I think, again, that's a combination of things going on there, but one of them is that that fund has just really hit stride in terms of its popularity. It's so large now that it is the go-to fund for a lot of investors, both in the U.S. and globally. So it's kind of like PIMCO Total Return in a way. It's a little bit difficult sometimes to tell whether that's part of a specific trend or whether it's just part of a wave of continuing cash that's just kind of automatically going into the fund. But as you seem to suggest, Michael Hasenstab, the manager of that fund, had gotten wildly popular, and that fund has become a story in and of itself.

Benz: Just a general question for you, Eric, in closing, when you think about the flows into bond funds that we've seen over, say, the past three years, do they worry you? Are you concerned that investors are maybe buying an asset class without fully considering some of the risks?

Jacobson: I'm not so much worried about what's going to happen next week or next month, but I am worried about a little bit farther down the line because I'm concerned that there may be shocks that people aren't expecting. Even for example if we don't have a major deterioration in credit quality and downgrades and defaults and what have you, it's very possible that we could have some sort of market volatility that knocks credit for a loop. And when you've got prices as high as they are and yield spreads as tight as they are right now for credit-based investments, that portends the possibility of a lot of volatility in the event that we have some kind of sell-off or some sort of market shock.

And I worry specially about people who have gone into those very niche categories, including high-yield, multisector, bank loan, and so forth. Hopefully, managers in the more active intermediate-term bond area, for example, multisector, where they have some room to manage around crises--the hope is that managers will be better at doing that. But right now everybody's got their foot on the credit pedal. So it's a little bit of a concern.

Benz: Eric, well thank you so much. It's always great to hear from you and great to hear your insights.

Jacobson: I'm glad to be with you Christine. Great to talk to you.

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

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