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Rising-Rate Concerns Push Investors to Noncore Assets

Christine Benz
Michael Rawson, CFA

Christine Benz: Hi, I am Christine Benz for Morningstar. Investors were buying bond funds again in the month of May, but their choices indicate a growing caution about the prospect of rising interest rates. Joining me to discuss the latest in fund flows is Michael Rawson. He is a fund analyst with Morningstar.

Mike, thank you so much for being here.

Mike Rawson: Thanks for having me, Christine.

Benz: Mike, the month of May was actually a good month for bond-fund flows, even though it wasn’t a great month for bond-fund performance. Let's talk about what investors were actually buying during the month.

Rawson: Well last year, going back to 2012, we saw very strong flows into the core intermediate-term bond category. People were plugging money away into bond funds. So far this year, particularly in the last few months, investors have been skeptical about that intermediate-term bond category and I think cautious about the prospect of the Fed tapering the quantitative easing measures. So what have gained assets recently are bank loans and nontraditional bond funds. Investors have really stopped adding to the intermediate-term core bond funds.

Benz: And you also noted that government-bond funds have been a weak pocket, too, because I think investors perceive them as perhaps especially rate-sensitive.

Rawson: Absolutely. I mean all you're getting there is interest-rate return. You're not getting the spread from potential improvements in credit. You have fixed interest rates; you don’t have the floating rate that the bank loans offer. So people have been very skeptical about adding money into these straight, traditional, safe core bond funds, government-bond funds. I say "safe" because they're safe if interest rates are in a flat or down-trending environment. These other nontraditional categories would be considered riskier. But they're going to hold up better when interest rates rise, and in fact they did last month. So last month the PIMCO Total Return mutual fund fell about 2%. The PIMCO Unconstrained fund fell only about 0.5%. So it held up a lot better.

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Benz: So PIMCO Total Return has been perennially on top of our list of the top asset gatherers. It actually saw a reversal in fortune in terms of performance and in terms of fund flows in the month of May.

Rawson: Yes, they had some redemptions, which I think is quite interesting. So this is the kind of fund that advisors love to use and love to put their clients into this fund. They kind of are outsourcing that interest-rate management to [PIMCO manager] Bill Gross. They say, "Look, we're not going to be able to predict interest rates better than Bill Gross. Let's just put our money in this fund." But recently we've seen a lot of flows into these less traditional bond funds or bond categories.

Benz: So you noted bank-loan and nontraditional-bond as big beneficiaries. Is there a risk, Mike, in your mind that maybe investors are underestimating their credit sensitivity of some of these categories and indeed the absolute loss risk?

Rawson: What is perplexing to me is that investors have been shy about going into equities, yet they are willing to go into these bond categories which do have more exposures to economic fundamentals and more economic sensitivity, so in essence it's a backdoor play on equities. You're getting some sensitivity to equities there. So I think in individual investors' minds sometimes they try to segment, "Here is my risk money; here is my safe money." Well, your safe money is supposed to be in bonds, and that's going to hold up well no matter what the economy does. It might not give you much of a return, but it's anchored to your portfolio. These other segments, they may hold up better if interest rates rise, but they're not going to be as strong if the equity markets sell off.

And so you have to ask yourself, "How much should I allocate to the ultrasafe part of my portfolio, whether it be bank certificates of deposit or bonds, and how much of that exposure can be economically sensitive?" Because certainly PIMCO Total Return has more sensitivity to the economy, to stocks, than government-bond funds.

Benz: So let's switch gears and talk about equity-fund flows. [May was] another negative month for U.S. equity funds. What categories were the biggest laggards in terms of fund flows?

Rawson: Sure, well growth has tended to be weak, and the reason why growth is particularly weak is because blend and value have been a little bit stronger. And the reason for that is a lot of passive funds sit in the blend category. Passive funds don't really take a position, so they tend to be large blend. And the value side has been strengthened by the flows into dividend and low-volatility stocks. Now what I think is interesting last month when interest rates started to spike--we had the 10-year [Treasury rate] going up about 0.5%, which is a significant move in interest rates--utilities and REITs had very strong negative months. In fact they were down about a little bit over 6% for utilities stocks and for REIT stocks, despite the fact that the S&P 500 wound up holding up OK. So you saw some interest-rate sensitivity on the part of these stocks. So a lot of investors have been piling into dividend stocks.

I think instead of going into fixed income, they said, "I'm going to choose dividend stocks because they're going to give me a better yield and maybe they won't be as interest-rate sensitive." Well, that's true, but if the whole market is doing that, well, all of a sudden if investors turn cautious, you could see a sharp pullback. And we saw that last month. So I think this is kind of a little bit of a prelude to what may happen if interest rates are to accelerate, and the Fed is trying to telegraph, there was a meeting this week, how they're able to manage expectations in terms of how quickly rates do rise. Eventually, we all agree they're going to rise, it's just a matter of when and how quickly.

Benz: Exactly. So based on fund flows, investors appear to be more sanguine about international prospects. Let's talk about the categories there that have been the biggest beneficiaries of investor dollars.

Rawson: Sure, well there's still some passive flow I think into the foreign large-blend category, and again I think that's mainly being driven by passive investors. And emerging-markets stocks generally have been strong. I don't think there's much of an active choice that investors are picking out these active mutual funds. I think it's more just passive flows going into those categories. Investors I think are a little bit more comfortable with Europe and still wanting to take on emerging-markets stock risk, which I think is interesting because emerging-markets stocks have been one of the weaker-performing [categories]. Hopefully we have investors who are looking at the long term, and in the long term [emerging markets'] economic prospects are much better. 

So, hopefully, investors are maybe ignoring the short-term noise, but it's interesting that the S&P 500 has been so strong during the past 18 months, but yet investors are still choosing these emerging-markets stocks.

Benz: Mike, let's talk about the fund families that have been the biggest beneficiaries. I think we've had this headline for a while now. Vanguard, again, leading the way. Is that mainly because of flows into the firm's passively managed products?

Rawson: Sure, so as you said, it's been the same story. So Vanguard is [the number-one beneficiary of asset flows], and is PIMCO number two. Vanguard always has a consistent flow from their passive products. Their Target Retirement Series are very popular in individual investors' 401(k) plans. So they have a constant flow from those sources, and they have also benefited from the shift toward passive, or index-based, investing. What was interesting in the month was that Vanguard launched the Vanguard Total International Bond Index and the Vanguard Emerging Markets Government Bond Index funds. 

Now, traditionally, the Vanguard Target Retirement Series is made up of just three funds; it's very simple. You've total U.S. stocks, total international stocks, and total U.S. bonds. Well, they are adding a fourth fund, and that's the International Bond Index. These funds are very large, so when Vanguard adds a new fund and shifts the allocation, it's very meaningful to the fund lineup. So this new international-bond fund is going to be seeded essentially with $10 billion, and that just began trading in June.

Benz: PIMCO you mentioned is number two in terms of asset gathering. Even despite outflows from the big PIMCO Total Return flagship, the firm still held up quite well?

Rawson: They did. So as you mentioned, the Total Return fund had outflows, and even the exchange-traded fund share class had its first month of outflows. Yet, the firm overall was still able to rank as the second largest in terms of fund families. So again, it was the strength of their non-traditional-type of bond funds.

Benz: Mike, thank you so much for being here to share your thoughts on the latest in fund inflows and outflows.

Rawson: Thanks, Christine.


Benz: Tanks for watching. I'm Christine Benz for Morningstar.