Why Did My Bond Fund Lag When Treasuries Rallied?

Although most of the drama has been in stocks, plenty of fund investors have been watching their bond funds closely during the past few weeks. The equity market's panic was enough to unnerve anyone, and with Morningstar estimates of taxable-bond fund purchases topping more than $630 billion since 2008, the "unnerved" probably includes a lot of us.

But while most can breathe a sigh of relief given that the average high-quality bond fund has enjoyed positive returns, those looking closely may wonder why their core bond funds didn't perform even better. The rally in 10-year Treasury note prices garnered some attention in the news as its yield sank to 2.14% by Aug. 10 even after Standard and Poor's downgraded Uncle Sam from AAA. For the brief run from July 27 to that point, its total return was a generous 7.4%.

So why didn't most bond-fund investors make a killing last week? For one thing, the 10-year Treasury note is a much more interest-rate sensitive--and volatile--individual security than the average core bond fund. Over the past few years, the duration of the 10-year has hovered above eight years (even passing nine at times), as compared with the intermediate-term bond-fund average, which has been around 4.5 years. That lower level of rate sensitivity was a good indicator that the impact of the Treasury rally wouldn't be felt as strongly by the average intermediate bond fund.

Things worked out pretty well for shareholders of Vanguard's  Intermediate-Term Bond Index (VBIIX) and close siblings  Vanguard Total Bond Market (VBMFX) and Vanguard Total Bond Market II (VTBIX) given their Treasury-bond-heavy portfolios. The former topped the category with a near 4.0% return, while the latter two gained 2.8% and 2.7%, respectively. But, the average intermediate bond fund (up 1.3% from July 27 through Aug. 10) simply couldn't come close to keeping up with the market's bellwether benchmark--the Barclays Capital U.S. Aggregate Bond Index, which returned 2.7%--over that stretch either.

The Wisdom of Crowds?
Why did the average core bond fund find itself at such a disadvantage? The simple answer is that coming into this period, the average intermediate bond fund had a much shorter duration (roughly 4.5 years versus the index's 5.2 years at June 30) and many fewer Treasury bonds, than the index.

The reasons for that leaning reveal quite a bit about the ways in which fund managers are trying to adapt to a post-financial-crisis bond market, the largest boom of bond-fund purchases in the industry's history, and palpable investor fear that rising bond-market yields will eviscerate their portfolios.

PIMCO's Bill Gross was a vocal proponent of the anti-Treasury case early in 2011 but backed away from that thinking as weaker economic indicators began rolling in more frequently. And while he allowed the fund's duration to drift closer to the category average around midyear, he too has continued to run  PIMCO Total Return (PTTRX) and its close siblings with less interest-rate sensitivity--4.6 years of duration at the end of July--than that of the U.S. Aggregate benchmark.

But even though a buildup of roughly 9% in net market value exposure to U.S. government bonds--including both Treasuries and government agency debt--has been at the root of that upward duration shift, it still represents a massive underweighting to the sector relative to the benchmark's weighting. Between Treasuries and government agency bonds--and not including government-backed mortgages--the index boasts a whopping 44% exposure. PIMCO Total Return therefore trailed way behind the index during the July 27 to Aug. 10 stretch, with a gain of 0.39%.

The managers at TCW/Metropolitan West have taken a similar tack with government bonds, holding only 11.4% in that sleeve as of June 30, with an overall portfolio duration nearly a year shorter than the index at 4.3 years.  Metropolitan West Total Return (MWTRX) posted a bigger gain than PIMCO Total Return's, but it too was well behind the benchmark at 0.87%. And while BlackRock's fixed-income CIO, Rick Rieder, has generally expressed a more bullish Treasury sentiment than many others,  BlackRock Total Return's (MAHQX) government bond stake of 24% as of July was clearly still well shy of the benchmark's, as was its 4.2 year duration. That fund gained 0.7% during the July 27 to Aug. 10 period.

The numbers clearly differ from fund to fund, but the trend away from U.S. government bonds has been notable and significant across the spectrum, as we discussed in a Fund Spy column in July. Ultimately, very few managers have been willing to bet on the kind of rally that just occurred among Treasury bonds by sticking anywhere near the benchmark's weighting--or that it will necessarily sustain itself going forward.

How Crazy Is the Fox?
That doesn't mean they're a bunch of Chicken Littles cowering from the threat of rising yields. A number of good, active managers have been expecting a very low-growth, sluggish economy with an economic environment producing perhaps 1% to 3% levels of inflation, rather than a strong recovery; most aren't talking about a wild yield climb in the next couple of years.

Yet they have also credibly argued that, while they have and continue to recognize that Treasury yields could grind down even lower yet, the risk/reward proposition of holding government bonds looks unattractive. In exchange for buying today's 10-year Treasury, you get paid only 2.3% to carry the risk that its price could slide a whopping 9.0% should yields rise 100 basis points from this point forward. And that's especially troubling to many with that 2.3% figure now so much closer to the zero-yield boundary. As  Osterweis Strategic Income's (OSTIX) Carl Kaufman argued to us recently, even if the United States were to "become Japan," it might imply a 10-year Treasury yield at 1.25%. He and many others will readily admit to having a lot more confidence in their ability to analyze any number of other bonds' credit or structural fundamentals over zigs and zags of the Treasury market, and in the margin of safety offered by the 150 to 600 basis points of extra yield that mortgages, high-yield debt, or emerging-markets bonds are expected to deliver over Treasuries.

In fact, as we noted previously, many such funds have traded away the rate sensitivity of their Treasury holdings for historic levels of high-yield credit and foreign bond and currency market exposure. Those with a lot of credit exposure, in particular, got a double whammy in early August when they missed the Treasury rally and suffered as high-yield bonds suffered with the stock market.

This trend further underscores the fact that few managers still view the U.S. Aggregate benchmark as a truly neutral indicator of the bond market. Few alternate weighting schemes have garnered sufficient support among institutional investors to permit a wholesale shift away from debt-issuance weighted benchmarks, but managers clearly aren't waiting for that to happen. Until now, the results have mostly been an issue of lagging in rallies as we've seen here, rather than an assumption of risks likely to more badly burn investors. These shifts are as important as any we've seen among core bond funds in the past 30 years, though, so it's worth keeping a closer eye on yours now as ever before.