Bond Funds Cut the Cord

The bond market's getting even more popular. Despite a gut-wrenching sell-off from late 2010 through January of this year, flows into bond funds have been massive. Taxable-bond funds took in more than $92 billion during the first half of 2011 alone according to Morningstar estimates. And even though municipal-fund flows were net negative by roughly $22 billion for the same period, both groups are still way in the black since December 2008, several months before the financial crisis began to ease.

In short, investors are pouring into bonds on an unprecedented scale. With more than $685 billion of inflows to bond funds since December 2008, we have not been able to find another period that comes close, even when adjusted for inflation.

A Brave New World?
If history is any guide, a lot of investors may not know exactly what they're getting into. In fact, there are notable differences in the way those dollars are being put to work today relative to how things were done in the precrisis era.

Bond managers who dominate the market for "core" strategies (the bulk of the funds in Morningstar's intermediate-term bond category) have made a clear move to shift assets beyond the sectors--such as U.S. Treasuries, agency mortgages, and high-quality corporates--historically represented in Barclays' Aggregate U.S. Bond Index. Most of their flagship mutual funds have long had some flexibility to invest in high-yield, non-U.S. (developed), and emerging-markets debt, but the allocations they're making these days are larger and many managers tell Morningstar these aren't temporary moves.

A combination of rock-bottom U.S. interest rates and worry about the nation's fiscal health is driving managers to higher-yielding assets. In some cases, the argument is that the healthy balance sheets of many foreign governments offer better long-term protection than Uncle Sam's does.

The numbers are stark.  PIMCO Total Return , for example, had 6% of assets in high yield and a whopping 24% in non-U.S. debt at the end of June. The latter number is especially notable given that nearly half of it is made up of emerging-markets debt. Those are easily the largest combined out-of-index bets PIMCO has made in years. And while large high-yield and non-U.S. weightings have typically been sufficient to push the flagship  Loomis Sayles Bond (LSBRX) into Morningstar's multisector category, that fund's May levels of 32% and 27%, respectively, are still eye-popping.

The same trend shows up in  JPMorgan Core Plus Bond (ONIAX), which boasts a 26% high-yield allocation and nearly 11% in non-U.S. debt.  BlackRock Total Return's (MAHQX) figures aren't as dramatic, but they too represent a shift. That fund had more than 14% in high yield at the end of June and more than 15% in exposure to non-U.S. bond markets. Those numbers exceed their levels from the past several years in just about every case.

Not Just the Popular Kids
Category-wide averages for allocations to the various asset classes would show that this trend isn't limited to these few examples. Unfortunately, differences in the ways funds report their exposures make the averages suspect. However, another data point--the funds' R-squared numbers for specific time periods--does make the case.

The statistic is typically used to denote how much of a portfolio's price movements can be explained by those of an index; a score of 100 suggests that a fund's movements are fully in sync with those of its benchmark. By looking at those data from periods before and after the financial crisis--skipping the crisis itself, which enticed most managers into opportunistic short-term, out-of-index bets--one can get a feel for how widespread the shift has been.

And in fact, comparing funds in the intermediate-term bond category with the Barclays U.S. Aggregate Bond Index shows a meaningful difference. On average, intermediate-term bond funds had R-squared values of 91 for the two years leading up to the start of 2007. That number falls to 82 when looking at the period from mid-2010 through June 2011, suggesting strongly that funds are broadly investing away from the index more than they were before the onset of the crisis.

A Whole New Ball Game
There are other indications of a major shift in the attitudes of managers and investors. The most prominent has been the meteoric ascent of bond funds with so-called unconstrained and absolute-return strategies. Although a lot of money has anecdotally moved into this group out of fear from future interest-rate hikes, it also represents a clear break from a tradition of core, benchmark-focused bond investing. These funds have taken in well over $1 billion per month in every month since September 2009. PIMCO's unconstrained offerings--including  PIMCO Unconstrained (PUBAX),  Harbor Unconstrained , and PIMCO's institutional separate account business--have been among the key beneficiaries of this trend. Morningstar estimates put PIMCO's flows into those strategies at more than $10 billion in the first six months of the 2011 alone.

That last stat is particularly interesting because of its juxtaposition with those at  PIMCO Total Return (PTTRX). That flagship offering has dropped from the very top-selling spot among taxable U.S. bond funds only twice in the past 10 calendar years, both times staying in the group's top five. For the first six months of 2011, however, it is second only to one other fund--in estimated net redemptions.

Just Because You Can Doesn't Always Mean You Should
In almost any other period, a trend of this kind would be an unambiguous red flag. Bond market history is rife with periods of yield chasing, followed by periods of sharp pain. We haven't gotten to the point at which today's trendiest markets are easily marked as overvalued, but they're approaching their 10-year highs.

Although it's tempting to scoff at any sentiment that smacks of "this time will be different," there are reasons to at least consider the possibility. That's because arguments in favor of emerging economies, in particular, are based on sound fundamental observations of their structural reforms, growth rates, and underlying fiscal health.

One of the dangers we've observed in such situations before, however, is that of the "me too" manager or fund company. It's relatively easy for many of them to ape the actions of a PIMCO or Bill Gross, for example, but much harder to actually replicate their success. And in this case, it's not even a foregone conclusion that market leaders such as PIMCO will live up to their past glory as they try to blaze new paths.