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Second Quarter in Bonds: A Damage Check

Christine Benz
Eric Jacobson

Christine Benz: Hi, I'm Christine Benz for

After a strong start to the year, bond market performance has fallen off a cliff since early May. Joining me to provide some commentary on bond market performance is Eric Jacobson. He is a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine, great to talk to you.

Benz: Eric, it's been a tough market for bond fund investors in recent months. Let's talk specifically about some of the hardest-hit categories since yields began to go up. We've seen long-government bonds hit hard, obviously, but what other categories have been affected?

Jacobson: Well, as you probably expect, the general, or more general, long-term bond category also has been clocked pretty good. For the quarter-to-date, it's down almost 5.5%.

The one area that I think a lot of people didn't really think about, if not expect ahead of time, was that inflation-protected bonds have gotten smoked pretty badly, too. They're down almost 7.9% for the quarter.

And one other area that is sort of off the big radar is high-yield municipals. They're down almost 7% for the quarter, and I think a lot of that has to do with liquidity in that space in particular.

Benz: I want to drill into muni bonds in a second, Eric, but before that, I wanted to get your take on another hard-hit bond sector, and that's emerging-markets bonds. What's going on there, and why have they been hit so hard in this recent downturn among interest rate-sensitive bond types?

Jacobson: That's another one that I think a lot of people didn't expect, because the talk of late has been so positive about emerging-markets bonds and the trends in fiscal health and so forth. But, as it turns out, there's been a lot of selling. A lot of it people believe to be of a technical nature, in the sense that the selling is begetting selling, and it's driving down prices. There is also some interest rate sensitivity there that a lot of people don't think about in the sense that emerging-markets bonds can be pretty tied to where Treasuries go on occasion.

The other thing is that, what's been going on in the market in general has been somewhat negative for commodity prices. If you look at the commodity broad basket funds, for example, they're down almost 9% for the quarter. And when you have commodity prices weakening, very often that spells problems for emerging markets that export a lot of commodities.

Benz: There's obviously been a lot of concern about slowing growth in China perhaps affecting commodities prices.

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I wanted to look at more credit-sensitive bond types, Eric, starting with high-yield--because we have seen those bonds sell off pretty significantly recently, and that's somewhat counterintuitive in that some investors might expect them to behave relatively well in a period of rising interest rates?

Jacobson: Yes, there are a couple of things going on there. Toward the beginning of the great spike, they actually did do a lot better than other areas. It's really been more in the last few weeks that things have gone sideways on them. I think some of it is just the fact that you started with what we call very tight spreads. The yields on high-yield bonds were relatively close to those of Treasuries, making them more rate-sensitive then you'd otherwise expect if they were at more normal yield levels.

You also have this sort of technical reaction, again, to selling in June. If you look at the flows compared with other categories, there's been quite a bit of money flowing out of high-yield bond funds and ETFs, and in general, people dumping the asset class. So that's part of that whole technical story.

What's interesting, though, is that bank loans have been almost the reverse; you have a lot of money flowing into them, about $25 billion for the year-to-date, and they've actually performed pretty well compared with almost every other category.

Benz: Before we move on to categories that have performed well, I just want to stop and look at munis specifically. You mentioned that the high-yield munis had gotten hit pretty hard, but really across the spectrum you see a broad-based sell-off in the muni market. What's going on there? Is it just that yields were so low coming into this, and so they just really haven't been able to offset some of the price weakness in the bonds?

Jacobson: That's exactly right. The municipal national long-term category also is down about 5.5% for the quarter, and as you suggest, it starts with low yields and what have been especially long durations when you compare them with taxable bonds. Some funds had shortened a little bit. The category average was 6.6 years coming into this time period, but that's still pretty long, especially compared with taxable-bond funds, many of which had durations of under 5 years. And if you live in one of the big, high-tax states like New York or California, you've probably gotten hit pretty badly because those [funds] have been skewed even longer, where the average duration was about 7.5 years.

And I should just say, if people are wondering why their muni funds were that long if everybody was worried about rising rates, a lot of that is just the fact that issuance tends to be very long in the municipal market, and it's very hard for managers to bring duration in too tightly, because if they want to generate enough income to attract investors, they've got to go out longer on the yield curve.

Benz: Switching gears, let's talk about the few bright spots for bonds recently. You mentioned bank loans were a rare pocket of strength. It would seem that anything that was shorter in duration or higher in credit quality would have also held up relatively better?

Jacobson: Yes, the short-duration area in particular has been among the leaders in that range. The quality issue, as we said with high yield, is a little bit tricky, because even the highest-quality bonds [were affected]; it really was most important to be short duration. If you were high-quality [and] long duration, it really didn't help that much.

But the bank loan story, again, is one that, for the year-to-date, they're up about 2.4%, which is considerably better than most other categories. They're still positive for the quarter-to-date. A lot of that was the flows, a lot of that was because of the fact that bank loans have a reset feature that allows their rates generally to flow with LIBOR. It protects them from interest rate sensitivity so that if rates go up, their income should go up as well.

I should point out that the link to LIBOR, which is, again, a very short-term interest rate. So, it's not actually an apples-to-apples comparison, which is why you don't have a perfect parity with rising yields at the long end, but they still, as you say, have been very, very popular.

One other area that's probably worth mentioning is the nontraditional bond category. That one has had a mixed bag. It still is negative for the quarter. The category has done better than quite a few others in the pantheon of fund categories, but I think that it's possible that some investors probably are still a little bit surprised at the fact that they're still taking losses for the quarter and for the year, even though the funds have been advertised as being very absolute return and not sensitive to interest rates, because most of them do have some duration, some interest rate sensitivity in their portfolios.

Benz: I'd like to switch gears and have you drill into some of the most widely held bond funds. Let's talk about PIMCO Total Return. It's having a rare off-year, a very off-year so far. Let's talk about what has detracted from its performance and led to these near-term losses?

Jacobson: Sure. It's a little tough, because the data for June is not out yet, but I can say that the trends, as you note, have been pretty poor for that fund. Going into this period of rising rates, the fund had a duration that was just short of the Barclays Aggregate benchmark, but still a lot longer than most funds in the category, and when I say category, I'm talking about the intermediate-term bond category that's sort of the home to most core, core-plus bond funds like this.

A lot of the duration for Total Return actually came from a very relatively small allocation to TIPS, though, and that has do with the fact that TIPS are relatively long in duration to begin with, and they sold off very badly during this stretch of time.

The other thing that we'll find out more about at the end of June, when the data comes out, but I suspect that to some degree the fund's emerging-markets allocation has been a problem as well, given how badly that area of the market has been clocked, and the fund has historically had some Brazil and Mexico and a little bit Russia as well, and Brazil and Mexico in particular have been badly beaten, along with the rest of the emerging-markets class.

Benz: A couple of other PIMCO funds, the Income Fund, which has been an enormous asset gatherer, as well as Unconstrained Bond, which is one of those nontraditional bond funds that you were just talking about: Those two have done relatively better, correct? At least relative to their peer groups?

Jacobson: Well, they've done better certainly than PIMCO Total Return. The interesting thing is, if you look at Unconstrained, it does have a comparatively short duration, compared to intermediate-term bond funds and a lot of the other categories, but it's actually done a little more poorly than its peers in the nontraditional bond category, and it looks, again, like emerging markets and perhaps the investment-grade portion of the portfolio [were the culprits]--as I've noted, investment-grade bonds actually sold off quite a bit … in sympathy with Treasuries.

If you look at PIMCO Income, again, it's got a shorter duration than a lot of other things, but it had a reasonably poor period of time as well, and it looks like a 20% allocation to emerging markets may be the reason there.

Benz: Let's look at the couple of other widely held funds. Met West Total Return, a longtime Morningstar favorite, is having a very good year and holding up relatively well in this period of turbulence.

Jacobson: The folk at Met West have been talking a lot about risk in the bond market and the concern about rising rates. So they did better than most in the category, thanks quite a bit to their shorter duration. Even though they are doing well, they're not doing as well as some of the top performers that have been even shorter.

Benz: Dodge & Cox Income, you note, has a similar story there--that duration has been very, very short and a corporate emphasis has helped it.

Jacobson: Exactly, and they've done even better because of it.

Benz: OK. DoubleLine Total Return, another fund getting very big flows over the past couple of years. Let's talk about it. It's performance has been very strong through here as well.

Jacobson: That seems like a relatively simple story; I don't have attribution for that fund. But I will say that it too has had a very short duration, certainly even shorter than some of these others, so it's just done fabulously well by comparison.

Benz: Eric, Vanguard Total Bond Market Index, a lot of hand wringing coming into this sell-off that it would perform very, very badly in a period of rising interest rates. Maybe it hasn't performed quite as badly as some people expected?

Jacobson: It really depends on what side of the fence you are looking at. There are a lot of extra share classes in the category. So if you're just looking on a gross basis, it may look a little better than otherwise, but if you screen out all the multiple share classes, it's right about in the middle of the pack for the intermediate-term bond fund.

As we've talked before, the average intermediate-term bond fund has a lot more of what we'd call a "core plus" look to it. And by "plus," I mean you've got some high-yield potentially, some foreign bonds, things like that--assets that are outside of the index

Normally, you'd expect that to help during an interest-rate-spiking period, but as we've alluded to as well, high-quality corporates have relatively long durations. They have tight spreads to Treasuries, and that's hurt. High-yield, again, you've had this technical selling and what we call spread-widening ... And again, emerging markets have sold off badly. You don't see that across the board; you do see it in some of the larger funds. But by and large, there have been things going on, especially over the last few weeks, that have hurt funds that go out of the middle-of-the-road area that the Aggregate is focused on.

Benz: Eric, last question for you. This has obviously been a very trying time for bond fund investors. They've seen a lot of volatility in the part of their portfolios that they really want to keep safe. So what counsel do you have to bond investors at this point? How should they be thinking about positioning their portfolios?

Jacobson: Well, as you know, Christine, it's really, really hard to predict the direction of interest rates. As we've seen over the last few weeks, it's taken a toll on even some of the smartest investors.

But if you believe what many managers think, which is that we're relatively close to the top of where high-quality Treasury rates are going to ultimately go, at least for a while, based on the fact that fundamentals of growth and unemployment don't seem to support yields going much higher than this, and additionally I would also mention that a lot of this has had to do with the QE3 announcement and the fact that the Fed is tapering off, or talking about tapering off, their purchases of bonds, then there actually could be a lot of value in fixed-income right now. I don't want to say that with any certainty, because we still don't know where rates are going, but we've moved so much in the last six weeks that yields are much higher than they were, that could present an opportunity, depending on what kind of manager you have.

So, if you are of the mind that we've gone about as far as we're going to go for a while, you probably don't want to exit the market or take your money out of bond funds while things are down like this.

My broader point, however, would be, you don't want to take your eyes off the ball of what your long-term goals are, and how much risk your portfolio can tolerate, because even with this sell-off, bonds still offer some ballast against other asset classes that tend to be more volatile. And you want to just make sure that the mix is right for you given what your risk profile is and what you're saving for.

Benz: Eric, that sounds like sound advice to me. Thank you so much for being here today.

Jacobson: Glad to be with you Christine. Thank you.

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