Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As stocks fell during the third quarter, high-quality bonds held their ground. Joining me to provide a recap of third-quarter bond-fund performance is Sarah Bush--she is director of fixed-income strategies for Morningstar.
Sarah, thank you so much for being here.
Sarah Bush: Thanks for having me, Christine.
Benz: A tumultuous quarter for stock investors. Let's discuss how bonds performed, but let's start by backing up and talking about the Federal Reserve's role in all of this. They backed off raising rates in September. What's the outlook for what 2015 will mean in terms of the Fed's actions? Do people think that the Fed won't act anytime this year?
Bush: That was definitely one of the big stories of the quarter--that the Fed didn't raise rates. In trying to figure out what happens from here, I think it's important to understand why the Fed hasn't raised them. They mentioned that inflation was running below their target and also that global turmoil, both financial and otherwise, is a potential break on economic growth here. So, I think that those are two factors they are definitely looking at.
As we talk to managers, I think there are more and more who think that we probably won't see the Fed raise until 2016--certainly late 2015 at the earliest. The CME has a projection around when the Fed futures suggest that the Fed will raise, and we're now looking at a very low, less than 10% probability in October and just under, I think, 40% for December. So, I think there are still a lot of questions out there about whether we're going to see a raise this year.
Benz: In terms of how performance played out among bond funds, let's discuss some of the hardest-hit areas. Not all bonds performed really well during this period. As you might expect, emerging-markets bonds and bond funds struggled a little bit. Let's talk about that.
Bush: Emerging-markets bonds have had a rough time--and especially local-currency emerging-markets bonds really had a very rough quarter. Anything associated with Brazil local currency or Brazilian corporates was particularly hard-hit. PIMCO actually has a fund that's an emerging-markets local fund, and that was one that had a particularly rough quarter.
Benz: High yield was another space--perhaps a little more widely held sector of the bond market. High-yield bonds sold off significantly during the quarter. Let's talk about that.
Bush: High yield had its worst quarter since the third quarter of 2011, so it was a rough stretch for high yield. Obviously, energy-related high yield has been coming under pressure for some time now, but we also saw weakness in other sectors like telecom and healthcare. So, when you look at the high-yield category broadly, there's actually a pretty wide dispersion of returns. The short-term higher-quality funds are doing OK; some of those even have positive returns for the year to date. Vanguard High-Yield Corporate (VWEHX), which focuses more on BBs, which are kind of the higher-quality end of high yield, is down a little bit but still having a pretty good year. Others with very large energy stakes, though, are really suffering. Franklin High Income (FHAIX) has had a rough quarter and is also down significantly, year to date.
Benz: Segueing over to the bond-fund types that did really well during this period, let's talk about some of those categories where investors may have experienced perhaps a positive return even as their equities were struggling.
Bush: So, we've actually seen kind of a seesaw in Treasuries. They had a rough second quarter, but they had a very strong third quarter--especially if you're looking at the long intermediate-term parts of the curve. So, it was definitely kind of a risk-off flight-to-quality type of environment and Treasuries did well.
Benz: And the Barclays U.S. Aggregate Bond Index, which a lot of bond-fund money tracks, did that hold its ground pretty well given that it is so dominated by U.S. government bonds?
Bush: Yes, the Aggregate Index did well. This year, it's proving to be a difficult bogy for intermediate-term bond funds to beat, I think, in large part because a lot of those funds have a lot more credit risk and less Treasury exposure than the Aggregate Index.
Benz: How about munis? What was the situation there?
Bush: Munis have held up relatively well. With Treasuries doing well, you'd expect high-quality munis to do well, but high-yield munis actually did pretty well in the third quarter, too.
Benz: One story that I know you and the team have been monitoring very closely has been the situation at PIMCO. It's been a year now since we saw Bill Gross depart PIMCO. Let's discuss the state of the state at the firm. I know that you and the team have been in frequent contact with PIMCO. You've made visits there. Now that the dust has settled, have there been any personnel departures--anything that you and team think are red flags?
Bush: One of things that I think everyone was concerned about when Bill Gross left the firm was that you'd see a lot of turnover in the senior investment ranks; either people would leave to join him or go to other firms. And while there have been a couple of high-profile departures, that senior investment team has been really stable. So, that's very encouraging, one year from his departure. When it comes to morale, I think it's very difficult to get a good read on it from the outside; but certainly from what we can see, it seems to be relatively strong.
Benz: Another thing that I know you and team had been monitoring were the potential repercussions of outflows from PIMCO Total Return (PTTRX) and whether that would have ramifications for performance or whether they would have to sell things they might otherwise keep. How has performance panned out at PIMCO Total Return so far?
Bush: We definitely are watching outflows. Outflows were huge right after Gross' departure, but they have tailed off. They are still running at a couple of billion dollars a month, but certainly given the size of the fund, that doesn't raise any red flags in terms of PIMCO's ability to manage it. And performance has been generally solid. It's been a really lean year, and PIMCO had a little bit of a rough September because of some of its holdings in TIPS and some of its yield-curve positioning. But as of early October, the fund is, again, looking pretty good relative to the category, although it is lagging the Aggregate Index by a bit.
Benz: A lot of investors pulled their money from PIMCO Total Return and parked it in other intermediate-term bond funds. Can we discuss some of those funds that were big beneficiaries of Bill Gross leaving PIMCO Total Return?
Bush: MetWest Total Return (MWTRX) was the biggest beneficiary. Interestingly, we did see some significant flows into passive; Vanguard Total Bond Market Index (VBMFX) saw significant flows. Some other usual suspects--Dodge & Cox Income (DODIX) and DoubleLine Total Return (DBLTX)--saw big inflows. Then, there were some surprises. Baird, which is a small bond shop in Milwaukee: We cover their Core Plus Bond (BCOSX). They have seen quite a few inflows. It's a very straightforward, plain-vanilla, cheap approach, so it's kind of understandable; but that's a fund that's grown quite a bit.
Benz: Sarah, thank you so much for being here. It's always great to hear your insights.
Bush: Thanks very much, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.