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Investors Continue to Take on Credit Risk

Christine Benz
Michael Rawson, CFA

Christine Benz: Hi. I'm Christine Benz for Investors appear to be taking a cautious tack in the month of October based on recent fund flows. Joining me to discuss them is Michael Rawson. He is a fund analyst with Morningstar.

Mike, thank you so much for being here.

Michael Rawson: Thanks for having me, Christine.

Benz: Mike, you said that fund flows during the month of September were pretty tepid overall in terms of flows into equity funds as well as bond funds. Let's talk about what investors were buying and what they were not buying during the month.

Rawson: Yes, flows to U.S.-equity funds certainly were tepid; we saw weak flows there and outflows again from taxable-bond funds. We did see some strong flows to international-equity funds. That [category] was a bit stronger, and it's been strong year to date. Investors may be finding value in international markets, whereas they're not seeing as much value in the U.S., and still we have this continuation of outflows from fixed income. Of course, June was the big month there where we had massive outflows, record outflows from fixed income.

Benz: Poor performance was driving some of that, I'm sure.

Rawson: Sure. We had interest rates really spike starting in May and June, and interest rates really went up throughout the third quarter. Then they settled down a little bit when the Fed decided kind of a surprise move that they weren't going to begin tapering, but still we've had continued outflows from taxable-bond and municipal-bond funds.

Benz: I want to drill into some of these headlines a little bit more, but first, you noted in your recent report that during the month of September anyway that money market funds led the way in terms of new inflows. What do you think is motivating investors to be looking at cash right now?

Rawson: Money market funds, as you mentioned, had strong flows for the month and really for the quarter. In fact, for the quarter, they had about $90 billion inflows. That beat out the $11 billion inflows in mutual funds and the $53 billion inflows into exchange-traded funds. Of the three, mutual funds, ETFs, and money market funds, investors seem to prefer money market funds. I think there are two things driving that.

First of all, we've had outflows from fixed income. There are probably a lot of fixed-income investors who are saying, "I need to shorten my duration [a measure of interest-rate sensitivity], so I am going to sell my intermediate-term bond fund and move to a money market fund."

Then I think also you have maybe some just caution on the part of equity investors or just investors generally that they want to put money into savings and are not sure whether they want to go into the equity market at this point where valuations might be fully valued. There maybe is not as much return potential in equities. So, they're choosing to go with the money market funds and are being a little bit cautious here.

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Benz: So even though yields are still very low, investors are feeling like they'd maybe rather be safe than sorry.

I want to spend a little bit of time, Mike, talking about the very strong outflows we've seen from municipal bonds. You noted we had that interest-rate shock back in the summer. Are there any other factors that you think are motivating muni investors?

Rawson: I think credit might be part of the concern investors are having. Whereas in taxable bond, the broad category group, we include both intermediate bond, kind of your plain-vanilla core bond funds, and also a lot of other categories within taxable bond which are seeing inflows. So, while you're seeing strong outflows from intermediate-term bond funds, you are seeing some inflows into bank-loan funds, nontraditional bond funds, and short-term bond funds. These are categories that have been popular for a few months now that we've talked about.

Benz: That's in the taxable space. They have been offsetting some of the outflows from some of the other stuff.

Rawson: Exactly. If you look at the intermediate bond category, look at the magnitude of the outflows, it's similar to the magnitude of outflows you see in municipal-bond funds. But on the municipal-bond fund side, there really aren't those offsetting categories where you're seeing inflows. So, it may look like the outflows from municipal-bond funds are worse. Probably the reason why it looks worse is that they don't have those offsetting inflows, but there is some truth to the idea that there are some credit concerns in the municipal-bond space.

We have the Detroit bankruptcy. Puerto Rican bonds have sold off. There are some credit concerns, but I think primarily what's driving it is interest-rate concerns. People want to shorten their duration [a measure of interest-rate sensitivity], and so municipal-bond funds have a lot of interest-rate risk, typically not as much credit risk, in general. So I think the selling from municipal bond funds is primarily a reflection of the interest-rate risk that's there.

Benz: Have you looked at the issue of whether we continue to see these outflows in munis, could that affect the market because I know the funds are actually pretty big players there in contrast with other fund types?

Rawson: That's a good question, Christine. So, you have municipal-bond funds, which are primarily owned by taxable investors, whereas on the fixed-income side you have a lot of investors--whether they be in pensions or endowments--maybe aren't as concerned about taxes. That's an issue I think which warrants for the research that how are the outflows from municipal bonds affecting that market?

Certainly, you think of the U.S. government as being somewhat interest-rate-insensitive or they're going to pay what they need to pay, but certainly some small municipalities may be much more interest-rate-sensitive to changes in interest rates. So, if there are outflows from municipal-bond funds and interest rates tick up there, you think that could affect some municipalities more than on the bond side in the federal government.

Benz: Let's look at international. You touched on the fact, Mike, that we have actually seen pretty strong flows there, even though international markets have generally underperformed the U.S. year to date. What do you think is going on there in terms of motivating investors to add new money there?

Rawson: Valuations are somewhat maybe more attractive internationally than they are in the U.S. I think the risk in at least the developed international markets has subsided, at least the headlines have subsided, in terms of the potential for further destabilization in Europe. The European economy has generally improved. So, I think people are getting more comfortable with Europe. European funds generally had very strong flows. Most of the international flows that we see are accounted for the larger economy, such as Europe or Japan. So, we're seeing strong flows into those areas.

In really emerging markets, the flows there have stayed somewhat positive, particularly on the mutual fund side, despite the fact that emerging-markets economies have slowed down. So, I think maybe it's just a continuation of people being more cautious about the U.S. market and maybe seeing the international market as perhaps being a more compelling valuation. Flows there have stayed strong, to your point.

One fund in particular which has had very strong flows is Oakmark International, which is run by David Herro, Morningstar's International Fund Manager of the Decade. That fund recently closed after basically doubling in size to about $24 billion in a short period of time over a course of about a year. There have been some strong flows particularly on the active side of international, whereas in the U.S. the flows are very strong to passive and not as much on the active side. Internationally, we've seen a balanced flow between both active and passive funds and ETFs.

Benz: Another thing I wanted to look at and you had in your recent report is PIMCO has been pretty hard-hit so far this year; PIMCO Total Return has seen sizable outflows after great inflows in 2012. But you’re also seeing a little bit of weakening inflows in some other big PIMCO bond funds. Let’s talk about what's going on there.

Rawson: I think this is interesting. I’m not exactly sure what’s driving it; I haven't looked into it that deeply yet. But certainly back in June we had a massive outflow from bond funds, and PIMCO Total Return was deeply affected by that. We had strong outflows from PIMCO Total Return. But you're also seeing a lot of outflows from other PIMCO funds. Whereas at the beginning of the year you had mild outflows or mild inflows to some PIMCO funds, more recently you’ve got outflows from a broader swathe of, I think, PIMCO funds. In fact, two funds in particular which sit out was PIMCO All Asset and PIMCO All Asset All Authority. Those are funds of funds which invest in individual PIMCO funds.

Benz: They’re not just bond funds though, right?

Rawson: Right, they’re not just bonds.

Benz: They invest in a lot of different things.

Rawson: Yes. In fact, some of the funds that they invest in are PIMCO Income, PIMCO Real Return, PIMCO Unconstrained Bond; these are individual bond funds that these funds of funds invest in. So we’ve started to see outflows from these funds of funds, which is a little bit of a shift from what we had seen earlier in the year. So I think the selling at PIMCO has kind of spread to some of the other funds that PIMCO manages.

Benz: A tough year for PIMCO overall. I notice that you had in your recent report that DoubleLine Total Return has actually seen a little bit of slackening of flows recently too, despite very good performance.

Rawson: It’s actually beaten the category benchmark, the Barclays Aggregate Bond Index, but it still had strong outflows more recently. I think it’s interesting, PIMCO’s Total Return actually caught up to the Barclays Aggregate last month. So both of these funds, PIMCO Total Return and DoubleLine Total Return, I would characterize their performance as decent. Certainly, DoubleLine Total Return has beaten the category average, but you’re still seeing some strong outflows there. I think, again, people are just cautious of that, the potential for rates to rise further.

Benz: You touched briefly, Mike, on the active-versus-passive question in the context of international. How about when you look more broadly, what are the trends that you’re seeing in terms of active versus passive flows?

Rawson: Well, it’s still the case that the passive flows are much stronger into U.S. equity markets. In the U.S. equity space, passive makes about maybe 30% of assets, and there we're still seeing a lot of flows into passive, like the large-blend category, such as the total market indexes or the S&P 500 index. Those end up in large blend. Those funds are still seeing strong flows. So last quarter we had about a $53 billion inflow into ETFs and a big portion of that was into U.S. ETFs. So within the U.S. market you’re still seeing strong flows into passive products and weak flows into active products. But in a couple of other categories ETFs aren’t as dominant as they are in the U.S. base. For example, municipal bonds; municipal bonds are primarily active vehicles, so the outflows there are primarily affecting those active mutual funds. So it depends upon different asset classes, which asset classes tend to be more passive or more easily lend themselves to being indexed.

Benz: Right. Mike, when you look on the full gear or first three quarters of this year, what are the big trends that you observe when you’re thinking about how flows have gone?

Rawson: There’s been this dynamic shift. In January we saw huge inflows across the board. We saw actually a pickup in active equity flows into the U.S., but that really has reversed itself now. And the trend that we saw in the first several months hasn’t held up throughout the rest of the year. Beginning in March and April we started to see some weakening of flows into taxable-bond funds, and then certainly in June we had massive outflows from taxable-bond funds. So there’s been this shift, and going along with that shift is a shift for fixed-income investors taking on more non-interest-rate risk, whether it be credit risk, shortening their duration to get away from interest-rate risk, or maybe going into high-yield bonds. For a time there were flows into emerging-markets bonds. But people are trying to diversify their fixed-income portfolio away from taking just interest-rate risk. So I think that’s the big story of this year so far.

Benz: Do you think there are perils of investors doing that?

Rawson: Absolutely. I think people are avoiding interest-rate risk, but they’re taking on credit risk and non-interest-rate risk. But also generally they’re avoiding U.S. stocks. When they’re not putting money into the U.S. stocks--the U.S. stock market is primarily credit risk--they’re taking credit risk in their bond funds. So they may not realize that their bond funds are taking on more and more equitylike characteristics. Meanwhile, they're maybe not putting as much money into their equity funds because they're skeptical that valuations are full.

People have to be cognizant of the fact of the role of bonds in their portfolios, whether they be for diversification and for ballast, or whether you look for your fixed-income fund to provide you with some outperformance. Certainly, if you’re going into higher-credit-risk types of funds, you’re looking for some outperformance there. But it’s not going to hold up as well or provide as much diversification to your equity portfolio in the time of crisis.

Benz: Mike, thank you so much for being here to share your insights.

Rawson: Thank you, Christine.

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