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The First Quarter in Bond Funds

Christine Benz
Eric Jacobson

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

With the first quarter of 2014 winding down, many investors may be surprised to see their bond funds outperforming their stock holdings.

Joining me to provide a recap of the first quarter in bond funds is Eric Jacobson; he's a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: My pleasure, Christine. Good to talk to you.

Benz: Eric, let's start with the headlines. When you look across the bond fund categories for the first quarter, what were the big leader and laggard categories? Let's start with the leaders.

Jacobson: The big standout was a small category--not a lot of people own it, but you see this affecting your other funds--long-term government. The average for the year-to-date in that category was more than 8.3% positive total return.

[The category performance trend then] sort of goes down a logical progression, all the way down. The short-term bonds, ultrashort bonds, anything that didn't have a lot of interest rate sensitivity--including non-traditional bond, which includes the very popular unconstrained strategies right now--all are roughly near the bottom of the taxable-bond universe.

On the muni side, it kind of breaks down by state, but the national funds did pretty well, returning almost 4% for the year-to-date.

Benz: In the muni space, did the long-term funds do well?

Jacobson: Yes, they did.

Benz: Let's talk about that, Eric, because a lot of investors for a couple of years now have been bracing themselves for this interest rate jump. We did see one this past summer. But Federal Reserve Chairperson Janet Yellen indicated that the Fed would continue its tapering program, that it was in fact on course. So one might have thought that would have caused tremors in the bond market. Why did long-term bonds do so well?

Jacobson: Two things. One is that it's important to remember that whatever news there is about tapering and how it affects the market is very dependent on expectations before the news comes out. If the market, for example, expects her to say that tapering is going to continue at a particular pace and has already "priced that in," then you wouldn't expect to see a big reaction.

Now, in fact when you look at the year-to-date performance, a lot of what you're seeing here actually is the result of the fact that the market and the Fed were expecting arguably a little bit more economic growth and potential inflation over the course of this year, and the latest numbers that have come out actually have illustrated that the economy is growing slower than expected. And that had a very positive effect on the long-term part of the market, because the expectations for inflation and rising long-term yields were dampened significantly as that news came out.

Benz: You mentioned that economic growth has been not that great. Why did credit-sensitive bonds do so well, or do relatively well, during the quarter? One might not expect that to be the case.

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Jacobson: I think that to some degree it's actually almost a pooling effect in the sense that the highest-quality bonds rallied a lot. At some point, there is some sensitivity to that on the part of corporate debt, and especially high-grade corporate debt. Because when their yields get closer and closer to the highest-quality bonds, like Treasuries, they actually start to become more highly correlated, because their yields are so much closer.

I've got to put it in some perspective, too, by saying that, for example, long-term bonds were up about 8.3%, but the average corporate bond fund was "only" up about 3.3%. That was, however, better than the Barclays Aggregate, which is sort of the S&P 500 of the bond market.

So, yes, corporates and riskier assets did reasonably well; high-yield actually lagged investment-grade corporate, though. Again, a lot of it, I think, was actually interest rate sensitivity.

Benz: Let's touch on the laggards. You noted that the shorter you got, the worse you performed.

Jacobson: Right. Part of that is just an effect of relativity in the sense that if you didn't have the long-duration stuff, you didn't do as well. On the other hand, another partial factor there is that, when Yellen spoke, it challenged expectations about where short-term rates were going to be--in fact, more accurately, when they might actually start to go up. And her comments jolted the market a little bit, and very short-term bonds actually sold off somewhat during March in particular.

So not only did funds at the shorter end of the spectrum suffer in relative terms to funds that invested way out of the long end, but they were also dinged a little bit by short-term debt selling off in March in particular.

Benz: Muni bonds, you mentioned, did have a pretty good quarter. I think a lot of investors had given up on them in 2013, but we saw pretty strong performance there. Is that just an interest rate story, that they responded well to declining bond yields, or is there something else going on there?

Jacobson: I think it's a mix of factors. A lot of what I've heard [suggests] it's a little bit of a response to them having gotten cheaper. The fact that usually the first part of the year is sort of a good environment for municipals, and especially when you combine that perhaps with a little bit more interest when they got cheaper, and the fact that munis tend to be a very long universe. So that helps when long-term Treasury yields rally as well.

Benz: Let's take a look at some of the biggest, most widely held funds, and give a quick assessment of their performance. I know you have been very much on top of the PIMCO story from a fundamental standpoint, monitoring what's been going on with personnel and so forth. How about from a performance standpoint? When you look at PIMCO's big funds, the Total Return Fund of course as well as PIMCO Income, how do their numbers look?

Jacobson: For PIMCO Total Return, it hasn't been a disaster per se. The fund is up about 1.3% for the year-to-date through March 27. But at the same time, it really was not well positioned for the first quarter very much. Bill Gross has been focusing a lot of attention on the shorter maturities, and giving very short shrift to longer maturities, so much so that the fund is underweight at the long end and even has a modest short market position on long-term Treasuries.

So the sell-off in the short end didn't help, and certainly missing out on the rally at the long end didn't help. And even if you don't dig in that far, you can see that the fund's duration was pretty short relative to, say, the Barclays Aggregate.

Also, Gross has had a pretty consistent underweight in high-grade corporate bonds, to the tune of, say, a 9% weighting relative to about 22% in the Barclays Aggregate. So that certainly didn't help, either, as investment-grade corporates outperformed the broader market as well.

PIMCO Income is a little bit of a different story. Certainly that fund, because it's a PIMCO fund, shares some of the macro positionings with Total Return and other PIMCO funds. But it has a built-in advantage in some environments because of the fact that it has a healthy high-yield component. It also has a very healthy non-agency mortgage component. And because of the fact, as you pointed out, that risk assets actually did perform reasonably well--not as great as long-maturity Treasuries did--but that fund is still in the top quartile of the multi-sector category for the year-to-date. And at the same time, it has been beating the Barclays Aggregate as well. So things are looking pretty good at PIMCO Income.

Benz: MetWest Total Return is a fund that some investors have been using, maybe as a substitute for PIMCO Total Return. How has that fund been performing recently?

Jacobson: It has done a little bit better than Total Return. But it so happens that, from a macro perspective, the folks at MetWest have been a little bit more in sync with Gross and PIMCO than some of their competitors, and that has meant that they didn't have as much market sensitivity, either, and they're lagging the category and the index a bit for the year-to-date. That just puts them a little bit into the bottom half of the category.

Benz: DoubleLine Total Return is another fund that has gathered a lot of assets since its launch a couple of years ago.

Jacobson: Right. In that case, DoubleLine Total Return and some of the other funds run by DoubleLine are all doing reasonably well. Total Return is in the top quartile for the year-to-date. Again these margins are pretty thin, especially over a three-month horizon, but it's returned a little more than 2.5%.

Benz: We've been hearing from a lot of investors; I'm sure you have, too. There is kind of a crisis of confidence in bonds. People are really wondering, why do I need this asset class. Apart from relatively strong performance in the first quarter, what is the case for fixed income going forward?

Jacobson: I would argue that even if you look at that strong performance, flip it on its head and ask yourself, why did it have that strong performance? And the reason that it did is that expectations for economic growth and inflation turned out to be lower than the market was expecting.

That, in and off itself, tells you that to some degree all this concern about rising yields savaging bond portfolios is a little bit … overhyped. That doesn't mean that interest rates won't go up and that bond prices won't go down eventually at some point.

But, first of all, it may be a slower process over time than people expect, and second of all, this just goes to show you that none of us are really certain--including the Fed, including the market--nobody knows for sure how things are going to develop with the economy and the bond market. When you add to that the fact that bonds are still a very important insurance policy in a portfolio that otherwise has a lot of assets very correlated to equities, I think it's a real mistake to walk away from bonds too quickly.

Benz: Eric, thank you so much for being here to provide your perspective. We appreciate it.

Jacobson: Glad to be with you.

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