Bond 'Liquidity Storms' in the Forecast

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

Stocks posted tremendous gains in the first quarter, but bonds were decent, too. Joining me to discuss the recent trends in bond market performance is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Great to be here. Thanks, Christine.

Benz: Eric, it was actually a fine quarter for bonds in the first quarter, but it definitely appeared that investors were embracing credit risk over interest rate risk during the period. What was driving that trend in your view?

Jacobson: I think there are few things going on. One is that, we finally tapered off from the big rally in Treasury bonds last year. People started looking, I think, at the yields and agreeing that they were getting to be sort of unsustainably low, especially given that the other side of the coin was that Europe quieted down, things from Europe didn't seem to be as great a risk as they were before, and U.S. economic data started looking up.

And all those things, I think, backed up this idea that, as things have been going in the last year or so, more of a risk-on rather than risk-off kind of bond market. And anything that had some level of credit or, as we say, spread risk--risk above and beyond that of Treasuries--did really, really well in the first quarter of 2012.

Benz: So, let's delve into the categories that you would count among the best performing in the first quarter?

Jacobson: Well, the faraway leader was the emerging-markets bond category. And as you know, the flows there have also been very strong. The interesting thing about that category is that pieces of that market have been finding their way into more diversified funds as well. We've talked number of times about the fact that there are some emerging markets, for example, even in PIMCO Total Return, and firms that have that capability are looking to find ways to use it.

When you hear PIMCO talk about it, they look at it almost as a ... I hate to use the term "paradigm shift" ... but that's kind of what they're saying in effect--that emerging-market balance sheets are stronger, they have more flexibility in terms of their fiscal and monetary situations, and that they are just better places for your money right now, but clearly when you look at the history of the emerging-market bond category, there is plenty of risk there, too.

Benz: Right--junk bonds also had a very good period. What was driving that? Just the risk-on mentality as well?

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Jacobson: That's right and  ... at the point that Treasury rates got so low and get so low, everybody starts looking for where the great opportunity is for more income. And what looks really good about the high-yield bond category and even parts of the investment-grade corporate category--we don't have a fund category for [investment-grade corporates], but you see that kind of stuff in the intermediate-term bond funds, in your multi-sector bond funds sometimes--is that corporate balance sheets have just gotten very, very strong over the last year, as you know. Companies have been building cash. They has been de-risking among financial companies, and a lot of those firms' bond prices were considered way lower than they needed to be, their yields too high, if you will, last year. And so, I'm mixing this all together by talking about high-yield and investment-grade corporates in the same breadth, but they were both very strong parts of the market.

And then when you look across the rest of the universe, you're really looking at other things like the bank loan category, the multi-sector bond category, both of which ... and certainly bank loans ... have considerable credit risk, and multi-sector bond funds typically have a slice of emerging markets, some high-yield depending on the construction of the fund, etc.

And another really strong place in the market was the muni funds. Those that had more credit risk in particular tended to do quite well during the first quarter.

Benz: So, at the opposite end of the spectrum, high-quality, long duration didn't fare as well?

Jacobson: That's right. When you look at the list of categories on the bond side, you see a really stark list at the very bottom, which is short-term government, intermediate-term government, long-term government. In that order, with long-term government being way at the bottom. The three-month return for the category for the first quarter was minus 6.2%. And what we had there was a rate spike that happened in March. So, not only do those categories have no credit risk, but even a little bit of interest rate movement really gives them wallop.

Benz: So, a follow-up question for you, Eric. A lot of folks own funds that track the Barclays Aggregate Bond Index, and people have been waiting to see how these funds would behave in a period that kind of shook rate-sensitive bonds. How did the total bond market trackers come out during the period?

Jacobson: Well, they came out OK, which is not saying that much, because ... although we had a little bit of rate spike, it wasn't a runway rising rate period. It was relatively brief, and not that large in magnitude.

But your Vanguard Total Bond Market Index Fund and Vanguard Total Bond Market Index II, they each returned a little bit more than 0.2% for the quarter, which was a lot lower than some of the funds that take on a lot more credit risk, of course.

So, hopefully, it's a little bit of a sign for people that they need to be careful and that they need to understand what the ramifications are there, because even owning a little bit more aggressive intermediate-term bond fund--and when I say aggressive, I mean more on the credit side--might be beneficial to a portfolio that has too much index-like exposure, because so many active managers right now are not taking on as much interest rate as the indexes.

Benz: Right, and let's discuss another very prominent fund, the biggest mutual fund, PIMCO Total Return. I know investors like to get an update from you on what's going on there from a performance standpoint?

Jacobson: Sure, and what they did was, like some others, they added some risk at the end of the year in a variety of sectors that I talked about, and because of that, the fund did quite well during the first quarter, and now they are starting to pull back a little bit on that risk, in the view that that things have been very good and successful, but that we don't quite know where we're headed yet, especially with the problems that we still have in Europe and uncertainty here in the U.S. going forward. So they are not taking all risk off the table, but they are pulling back on it some from where they were.

Benz: Eric, I would like to just spend a couple of minutes here looking forward; we been talking about what went on in the first quarter, but investors have been piling into bonds--we've been seeing this trend for a couple of years--and I'd like your take on what investors should have in mind as they manage their bond portfolios. We've seen very strong flows into some of the credit sensitive sectors, emerging-markets bonds, junk bonds, etc., and I'd like your opinion for those investors when they think about what role such bonds should play in their portfolios, and any guidance you can give because it's obviously a vexing part of many investors' portfolios?

Jacobson: Well, I think the thing that a lot of people need to understand is that if you talk to the active managers who are in these markets every day, many of them view this as a very volatile time in the marketplace. And what I mean by that is, we keep having these swings up and swings down in terms of riskier assets. A manager I just spoke with over at Putnam referred to them as liquidity storms, and that means that money was pouring in really quickly and pouring out very quickly in terms of risk assets. And because of that, it's a little bit hard to sort of "set it and forget it," if you will, in terms of what's going on in portfolios, certainly active managers aren't doing that.

I think, to some degree, that it's just a warning for people not to become too complacent and think that they can just get out into cash, for example, when they are worried, because it's almost impossible to get back in at the right time. As you and I've talked before, I tend to advocate that people pick a manager they are really comfortable with and a strategy that they are comfortable with, and let the manager make most of those decisions.

Benz: Are you concerned that folks are chasing yield and maybe venturing into higher-risk securities than they have bargained for?

Jacobson: I certainly am. It's hard to tell people not to do that in the time when Treasury yields are so low, but it's so important for people to understand the ramifications of those decisions. As we said earlier, the emerging-market bond category has absorbed a lot of assets relative to its previous size, and that's a place where, even though the fundamentals may be better, there is always a lot of room for volatility if we have that sort of "risk-off" trade.

The same thing with high-yield, which has been getting a lot of assets--that's a market that is very susceptible to liquidity crunches one way or the other, and you may even be talking about something as simple as Wall Street stepping back, which they have been doing for the last year, and that really changes the profile of the market, and makes those volatility swings potentially a little bit greater.

So, absolutely, I think people need to be really cognizant of what they're doing and recognize that they may be changing the entire risk profile of their portfolio in an attempt to get some more income.

Benz: OK, Eric. It's always great to get your opinions on the bond market. Thank you so much for joining us here today.

Jacobson: Glad to do it, Christine. Thanks for having me.

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