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Bond-Fund Investors Walking Gingerly

Christine Benz
Eric Jacobson

Christine Benz: Hi. I'm Christine Benz for Stock funds posted very strong gains in the first quarter of 2013, but bond funds didn't fare as well. Joining me to provide a recap of the first quarter for bond funds in 2013 is Eric Jacobson. He is a senior fund analyst with Morningstar. Eric, thank you so much for being here.

Eric Jacobson: Sure. Glad to help, Christine.

Benz: Eric, when we look across the numbers for the first quarter, what we see is that bond funds didn't generate terrific returns in absolute terms, but some of the categories that did post relatively better numbers were some of the riskier categories. Let's talk about the types of funds that led the way in the first quarter.

Jacobson: Sure. Well, it's lot of the same story that we've talked about before in terms of what we've probably described as risk-on. The strongest categories during the first quarter were high-yield bond, the bank loan, and multisector bond, which has typically quite a bit of high yield and bank loan credit in it.

Benz: Is the thesis that investors are thinking, if the economy is improving, that in turn will help companies be able to pay their debts, companies with perhaps low credit ratings? What's going on there?

Jacobson: Yeah, to add a subjective look at it, I think some of that is justification for allowing people to feel comfortable with continuing to buy these credit-sensitive sectors that are getting richer and richer. As the yields go down and it generally becomes harder to think about, "Well, how am I going to get more return out of this," it's easy to take a look at the economic data and say, "well, things are going well, the default risk is relatively clean at this point, and so we can justify buying things at these lower yields."

Benz: So it sounds like you are concerned that there is kind of some yield-chasing going on, that's why investors seem to be buying some of these higher-income-producing categories?

Jacobson: Well, everybody is trying to find an alternative to Treasuries right now, and even mortgages don't have as much fire in them as they once did, and I'm speaking specifically about agency mortgages. So there is this just massive search on for anything that doesn't look as tight and risky as Treasuries. So, again, it comes back to, whether or not you want to call it yield chasing or not, that's pretty much I think what's going on. It’s just that it's even broader and inclusive of probably more investors than usual.

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Benz: Another category that saw relatively tepid results in the first quarter, Eric, is emerging-markets bond. That's a category that has been seeing huge inflows. What's going on generally within that category in terms of why the performance was as it was in the first quarter?

Jacobson: Well, there's some debate on that because there doesn't seem to be a super strong fundamental explanation. But what we've heard from a few managers is that, now with so much of that universe trading relatively tightly, and justifiably so from the perspective that so many countries now earn investment-grade ratings, that in fact, we're seeing more sensitivity to Treasury Bonds and the Treasury market than we've seen in the past, and higher correlation, if you will, from emerging-markets debt to Treasuries. So if you look at what happened in the Treasury market itself, even though the intermediate maturities kind of have been flat for the quarter, even though they spiked a little and then came back down, long-term Treasuries performed quite poorly for the quarter. So, any amount of that correlation creates a problem for the emerging-markets sector. Meanwhile, if you look at some of the larger countries that are heavily represented in the indexes, they are very commonly held by mutual funds, such as Russia, Mexico and so forth, and they have definitely sold off during the first quarter.

Benz: So you mentioned long-term Treasuries, Eric. That actually was the worst-performing bond category during the quarter. Let's talk a little bit about what drove that part of the bond market down.

Jacobson: Sure. Well, there are probably a few explanations for it, and again, this is something that people can debate about. But it looks like the economic numbers have been reasonably strong for the last few months, certainly with housing, until last month, looking good as far as I can tell. That seems to be really affecting long-term high-quality yields. So the Treasury market at the long end really got clocked for the quarter, and the investment-grade market sort of chugged along in the middle ground.

Benz: Eric, I would like to talk about some of the big funds, the most widely held funds in some of these categories. Let's start with the big PIMCO products, the Total Return/Harbor Bond/Total Return ETF. How did Bill Gross and the big funds do during that period?

Jacobson: Well, it's certainly helpful not to have a lot of long-term Treasuries. He kept the duration of the funds short of the benchmark by maybe three quarters to a year, and at the same time stayed away from those longest, most yield-sensitive Treasury securities. So that helped avoid a lot of the trouble. In the meantime, he's got some what we call spread sectors, not as much as he did last year, so it's that sort of high-yield, high-risk stuff. He had some high yield, a little bit of nonagency mortgages, and some emerging markets, as well. So that emerging-markets piece didn't do that well.

Overall, on a relative basis, the fund looks pretty good. The funds look pretty good relative to the intermediate-term bond category. Just as you said, the absolute numbers are kind of mild, but unfortunately, not all that different than what you might expect for a year like this that we're coming into on a quarterly basis. You shouldn’t expect really big numbers right now. What we've seen in the last few years is probably an [exception] compared with what we can expect going forward.

Benz: How about another one of Morningstar fund analysts' favorite active funds, the MetWest Total Return Bond? How did that do during the quarter?

Jacobson: I don't have actual attribution data for that, but our suspicion right now is that their strong exposure to nonagency mortgages may have been a big part of that success, given that they sort of trade with those higher-yielding sectors, and it looks like it's been a pretty good quarter for some of the pieces in that market. It's a little difficult to tell because it's kind of fragmented and fractured, but that's been a pretty good fund. Again, they've kept duration on the shorter side as well, not buying a lot of long-maturity Treasuries. To my knowledge, I don't have an exact portfolio in front of me, but I know that they've stepped into bank loans in some of their offerings to the degree that they may be in that portfolio. That certainly was a really strong sector for the year.

Benz: Let's touch a little bit, Eric, on the Barclays Capital Aggregate Bond Index. There are so many products that track that benchmark. How did that benchmark do during the quarter, and in turn those many investor dollars that are tracking the index?

Jacobson: Well, it's the flip side of the same story here, in that the high-yield sectors and the really more credit-risky sectors aren't really well-represented in the index. There's no high yield in the index. There's a very small slice of commercial mortgage-backed securities. A modest slice of asset-backed securities, which are not really high yield in themselves, but they are a popular overweight area for managers. So, at the same time, the index has a very significant portion of long-term Treasuries. I mean, it's market-exposure-weighted. So all the pain of that long-term Treasury backup mixed with not having very much in terms of the high-yield credit-sensitive sectors means that, to some degree, it got the worst of both worlds.

Benz: Eric, I don't want to ask you to look into a crystal ball, but I'm wondering when you talk to fund managers these days, what are you hearing? Are they saying that this could be sort of the beginning of the end of what has been just a tremendous multidecade bond market rally?

Jacobson: I think most managers are a little reticent about calling the turn quite at this point. But it certainly is evidence of what they've been concerned about for many, many months, if not a couple of years, which is that eventually we're going to start seeing stronger economic activity, and it is going to have an upward push on high-quality yields.

So to the degree that that's already started, or even if it plateaus for a while, there is still a strong expectation that it's going to happen eventually--that a lot of managers want to be short of the index, not take on as much interest-rate risk, and to the degree that they can hide out a little bit in these more yield-rich sectors, that's kind of what they're doing. And, of course, as of late, the housing market has looked relatively strong, and that's an area that a lot of people in the industry think is sort of the most important leading area because of how important it is to the economy. So all wrapped up together, again, it's part of this long-term concern about rising yields, and I think that's kind of where everybody stands right now.

Benz: Eric, well, it sounds like bond-fund investors will be walking on eggshells for a little while longer. Thank you so much for providing the recap.

Jacobson: Glad to be with you, Christine.

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