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Why Dumping Your Core Bond Fund Could Cost You

Christine Benz
Eric Jacobson

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

Fund flows can provide an interesting window into investor sentiment. Joining me to discuss some of the choices investors have been making in the realm of bond funds is Eric Jacobson, a senior analyst for active strategies for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: It's great to see you Christine. Thank you.

Benz: It's great to see you in person.

Jacobson: Thanks.

Benz: We're going to look at some of the flows we've seen into various bond fund types, and maybe you can give us a window into what you think is driving investor choices in some of these cases.

Let's start with nontraditional bond. There has been a gusher of new inflows into this category. You've been specializing in this group for a while now. Why do you think investors have been so attracted to this fund type?

Jacobson: Let me start by saying that lot of folks may have heard the term "unconstrained" ...

Benz: ... PIMCO's big fund is called "unconstrained."

Jacobson: That's correct. So that area dominates this nontraditional category. We use the name "nontraditional" because there are few other strategies that are similar, but they don't call themselves "unconstrained," so we wanted to have our category be broader, but it's really a lot of unconstrained funds.

That's a big part of it, because these funds have been marketed as not only go-anywhere, but go-anywhere and give your manager lots of latitude, not just in terms of sectors and so forth, but also in terms of managing interest rate sensitivity.

As we've talked about for the last several years, a number of these have been relatively short, but with the promise that they can go longer if necessary, and they can go negative if necessary. It's just been a huge success for the industry, and it's worked wonderfully well from a sales perspective, because up until recently, people have been pulling money out of their core funds that have rate sensitivity, and trying to escape to something like this.

Benz: The interesting thing is, when you look at performance, some of those core fund types that investors had been pulling their money from have actually outperformed some of the nontraditional bond funds, in part because of their greater rate sensitivity.

Jacobson: That's exactly right. This is something that I think people really need to try and understand better, because it says something about both categories. I have been harping on this: The nontraditional category, as much as the focus and discussion is all about rate sensitivity, and the fact that they're going to be safer because they're either shorter or very tactical, most of them have tried to make up for the low-return possibilities with more credit risk. That has a lot of impact on how they've performed.

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The third quarter of 2011 was a rough period. It was really rough if you look at just the category averages--that whole category performed way more poorly than intermediate-term bonds. It didn't last that long, so it didn't kill the numbers, but that's something people really need to understand.

By contrast, as rates have been more friendly, let's say, to the bond market than people expected in the last couple of years, you've had the intermediate-term bond funds perform better. When I say the last couple of years, I'm not talking about last summer, obviously; that was a rough period. But the period since then, year-to-date rate, sensitivity has helped a lot more.

Benz: Another category that you've touched on, intermediate-term bond, tends to be the core-type bond funds. You note they tend to have more interest-rate sensitivity than typically comes along with these nontraditional bond funds.

Let's talk about flows there, because there have been some interesting patterns. Investors were jettisoning intermediate-term bond funds. Now, more recently when we look at flows, it looks like they've been coming back to them. What's going on there? Is it just that they've performed better?

Jacobson: I suspect that's a part of it. I suspect that a part of it is rethinking on some investors' parts: Should I really have taken all my money out of something that all of a sudden is doing well now? By the way, rates are looking like they may stay lower for longer. In that scenario, you probably still want to have some rate sensitivity. And not even necessarily as a bull play, but as some ballast to your portfolio. We've been harping on that, too. Don't take ballast out of your portfolio.

I don't know where the future is for that. Up until recently, this was starting to look like a dead category for growth anyway in the eyes of the fund industry. They've been bleeding assets for well over a year, I want to say, up until these last several months. It's an open question as to whether this little bull period where people are putting money back in, how long that's going to last. I think a lot of it's going to depend on how interest rates go.

But these things are obviously very cyclical. At some point, rates probably will go up. We don't know when that might be. We kind of hope they do eventually, because that's going to signal good growth in the United States, and if we don't get that, it's going to be hard to see that happen. But assuming that they do, the environment that we live in after that is going to be a different environment than we have today.

Benz: But for people who are looking for that sort of ballast, if they've got a lot of equities in their portfolio, the intermediate-term bond fund space is probably a good starting point, versus messing around with some of these noncore categories.

Jacobson: Right. I think the most important thing is that, especially when you get into those noncore categories, so many of them have equity sensitivity--high yield, etc.--and it doesn't mean that you don't want that, maybe you do. But if you strip out all the rate sensitivity by getting rid of your intermediate-term bond funds or government funds, at that point, you've taken away an insurance policy. If you go back and look at the third quarter 2011, go back and look at 2008, the only thing that did well in those periods were U.S. Treasuries. And if you go back and look at '08, munis didn't even do well, even though they usually have a lot of rate sensitivity.

So, it's an insurance policy, and if you're looking at a relatively modest percentage of your portfolio, and you're thinking, I need to get rid of this because I'm afraid it's going sell off, think again, because you don't want to be predicting interest rates. You don't want to be doing that in your portfolio, and the one time that you are really going to need it, if it's not there, everything is going to go down at the same time.

Benz: Speaking of those more credit sensitive categories, another category that falls under that umbrella is the bank-loan group. We've seen some interesting patterns there, really strong fund flows into that group for a couple of years, especially in 2013. More recently, though, there were some outflows. What is going on there and driving investor flows?

Jacobson: The first part of it is a lot easier to explain than the second. And I'll say that those flows in were really a healthy combination in terms of, first, a desire for investors to get more yield. Because of the credit sensitivity of bank loans, they tend to be highly leveraged companies, bank loans offer higher yields than a really big healthy company would be offering. But that floating rate feature also has made them attractive during that whole inflow period, because people were so afraid of rising rates. So, the theory is that if rates go up, you're going to be not only well-protected, but these funds will actually perform pretty well because their rates will reset, and as long as rates are going up anyway, it usually means the economy is doing well, and bank loans themselves fundamentally are going to do better.

Benz: I think it looked like the perfect category in a lot of ways to a lot of income-seekers.

Jacobson: Exactly. We actually had people stand up at our conference this year, and say, "Why are you badmouthing this category? They're just as safe as money market funds," which put a shiver down our spines, because that's the thing we've been saying for years and years and years not to think. And it's true. You go back and look at how they performed in '08. That was not how they acted at all.

But now we're talking about this period, where flows turned a little bit negative. And, again, we don't know for sure. There is a lot of talk in the market about this. One possibility that I think is interesting, though, goes back to this whole question of rates and the Fed and this idea that growth hasn't been as robust, or wasn't a little earlier this year, as expectations. That tends to push out expectations for when short-term interest rates may eventually go up.

That's really crucial to this category, because right now even though they have been so popular, their yields are very small, and the only way for these things to really do better in terms of income is for short-term rates to go up, and there is even going to be a little delay probably, because most of these loans have floors, so that rates have to go up a certain amount before they'll even start to catch up. I think that explanation is a possibility. There may be other things going on. We're still talking to people trying to figure out if there are things that we haven't thought of yet.

Benz: You would say to people who are looking at this category, understand the credit sensitivity that's embedded in these holdings. How should they think about these funds as being part of their total portfolio?

Jacobson: In terms of bank loans especially, throw it in with your high yield in terms of thinking about risk. Both of them are going to be relatively more correlated to equities. Especially during those stress times, they hopefully won't go down as badly as your equities--that's an advantage, obviously--but they are still going to move that way.

Back to the question about portfolio building: that's a tricky one, because they don't have the rate sensitivity generally, and so it's not exactly a ballast; it's more of a tweener. The idea being, though, that you're hopefully getting more income, you're hopefully walking that line, and a lot of people like the bank loans because of the rate thing.

I will say this, though. Both categories have gotten relatively rich.

Benz: Both high yield and bank loans.

Jacobson: Both high yield and bank loans. I'm not going to make a specific call about where they are today. They do tend to get better and worse over a few weeks' time period depending on what's happening with rates. But in general, all that money that has flowed into those groups in the last year, or couple of years, has brought down yields, brought prices up, and made them, as we say, tighter.

Benz: Right. So you are not getting paid to take that extra risk.

Jacobson: Right. And a lot of people will rationalize and say, the economy is doing fine. These companies are healthy. They've got a lot of cash, etc.

Benz: Default rates have been low.

Jacobson: Default rates have been very low. So that's a reason to reassure yourself that things are OK, but the fact of the matter is--and this is the main worry that a lot of these managers have--they don't necessarily expect that there is going to be a rash of defaults coming up at some point. Some exogenous market shock, however--who knows what it would be, something in Europe, maybe bad things in the Middle East--something that creates a lot of volatility, especially if it comes in the equity market, can easily cause a big sell-off. We don't have the liquidity we did several years ago, because the banks aren't out there making markets in these things.

So, if they are selling off and the banks aren't buying them and liquidity issues are popping up, you can definitely see prices fall a lot if there is a shock to the market.

Benz: Eric, thank you so much for being here to provide your perspective on the choices that investors are making among their bond funds.

Jacobson: My pleasure, Christine. Thank you for having me.

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