The Great Yield Chase

We've been watching and discussing the trend for some time, and it doesn't appear that core bond fund managers are letting up. With Treasury yields at rock-bottom, and worry about the eventuality of rising rates gripping many investors, there are plenty of funds that continue to tilt away from the broad-market investment-grade bellwether, the Barclays U.S. Aggregate Bond Index.

The data is tricky to pin down, but the picture is clear. We've written in the past about how much funds' correlations have drifted away from the Barclays index. One reason for this is the divergence between the performance of certain subsectors--think corporates and agency mortgages--and the Treasury-heavy index itself. But there's also continued evidence that many--though certainly not all--managers are treading lightly in Treasuries. Indeed, while it's not unusual for funds in the intermediate-term-bond category to underweight Treasury and agency bonds, they have, on average, about 30% exposure to those sectors versus more than 46% in the Barclays U.S. Aggregate Bond Index. Typical funds' agency mortgage stakes are also below those of the index. That leaves considerable room for other sectors that are either lightly represented in the index, or not at all.

We thought we'd take a look at some of these sectors and why managers continue to favor them in portfolios.

Corporates
This is the most conventional route that most managers are taking when it comes to getting away from their benchmarks. Corporates account for roughly 22% of the Barclays Aggregate--which reflects market issuance--and numerous funds have bumped up their allocations to the sector. Some managers are even more adventurous; we've seen anecdotal evidence of more high-yield debt sneaking into core portfolios as well. The reasons are pretty straightforward. Company balance sheets are about as healthy as they've been for many years, with cash holdings reported to be in the trillion-dollar range in the U.S., and default rates are at multiyear lows.

The problem is that by nearly any measure, yields--and their spreads above Treasuries--for investment-grade corporates are near or below their multiyear lows. On average, they clocked in around 1.3 percentage points above comparable Treasuries around the middle of April 2013. It's no secret how they got there, of course. In addition to the aforementioned attractive fundamentals, buying has been strongly encouraged by central bank policies, not least of which have been the Federal Reserve's quantitative easing programs. They have played a major role in suppressing agency mortgage and Treasury yields, which has pushed investors to take on more credit risk in search of more yield.

Commercial Mortgage-Backed Securities
This one may surprise folks who haven't looked inside their portfolios for a while. The CMBS market represents only a modest 1.8% of the Barclays U.S. Aggregate Bond Index, but we've been seeing some meaningfully higher allocations to the sector as of late.  BlackRock Core Bond (BFMCX) and  BlackRock Total Return (MAHQX), for example, each held more than 11% there at the end of February.  Hartford Total Return Bond (ITBIX) was recently turned over to Wellington Management to subadvise, and the new team has elected to keep a healthy 10% CMBS allocation in that fund. Other funds such as  Artio Total Return Bond and  Fidelity Total Bond (FTBFX) have held stakes in the CMBS sector on a more strategic basis, but there's no doubt that it has become a popular destination.

The reasons why managers have favored the sector overlap somewhat with those underpinning the popularity of investment-grade corporates, including central bank policies and investor appetite for higher yields. More specifically, though, there are technical and structural reasons behind the sector's appeal. There have been new private-label (as opposed to agency-backed) CMBS deals underwritten in recent years, but net supply of available securities has been shrinking.  JPMorgan (JPM) estimates that net issuance in the sector dropped nearly $50 billion in 2012--close to a 10% decrease--and forecasts that some $30 billion will drop out of the market in 2013. That's part of an overall trend among securitized products, and the scarcity of supply has helped drive up prices. There are more specific features of the market that have drawn managers' attention, though. Some have told Morningstar analysts that high-quality CMBS structures created before the financial crisis are available with significant subordination, such that a lot of other investors would have to take losses before they would be affected. Given the scarcity issue, meanwhile, some have noted that it's difficult to find very super-senior pieces in the marketplace, making many reluctant to sell.

Emerging-Markets Debt
It's unusual to see emerging markets take up quite as large an allocation as other spread sectors in core funds, but the trend of holding them has certainly gained acceptance. For example, as of March 31,  PIMCO Total Return (PTTRX) held 7% of assets in the sector--an allocation whose $20 billion size tops that of every single dedicated emerging-markets bond fund--and those bonds are sprinkled in funds throughout the PIMCO lineup. (Even the firm's  Low Duration (PTLDX) offering boasts a 5% stake.) PIMCO's emerging-markets team has been favoring the debt of once less-respected markets that are now considered among the best capitalized, such as Russia, Mexico, and Brazil. They've also ventured into quasi-sovereign and corporate bonds. By virtue of its size, Total Return is a bellwether for competitors, and not just in terms of performance. If manager Bill Gross is doing something in that fund, it's akin to a Good Housekeeping Seal of Approval for other managers to employ the same tools.

Again, investors have been egged on here by developed-markets central bank policies meant to get them investing in higher-risk assets. It's a byproduct of those policies that assets have not only poured into U.S.-based investments but also into emerging bond markets of all kinds--including both sovereign and corporate sectors in many cases. Although it's tempting to write off these decisions as pure yield chasing, there is some evidence that these decisions are based on sound logic. It's undeniable that emerging-markets credit ratings have been on the way up. Notably, a whopping 68% of the Barclays Emerging Markets USD Aggregate Bond Index is rated investment-grade--versus only 39% five years ago. Those endorsements from the rating agencies are based on a number of factors, including economic structural reforms and growth rates that are meaningfully higher than in developed markets. The underlying balance sheets of many emerging economies, meanwhile, look increasingly appealing when compared with the debt-laden, major economies of the West.

The ultimate questions for investors whose funds have been finding their way into these sectors are whether they will stand up to trouble down the line and whether their funds still line up with their expectations. There's a tension between trying to provide the best possible returns when things are going well and maintaining the kind of portfolio that should provide better diversification in the case of volatile equity markets. In each of the cases we've explored, investor demand has significantly pushed prices up and yields down. Those new lower yield levels suggest that even under the best circumstances, the prospect for future returns is muted. Meanwhile, there's reason to be wary of how these sectors will perform under stress scenarios. Most managers aren't expecting a repeat of 2008, when Treasuries rallied and risky assets sold off, but it's nearly certain that bumps in the road will crop up at some point, and there's reason to worry that a dearth of yield may be causing investors to take on more and more risk than they realize. The lesson isn't a new one. It's crucial to know what your core funds own, and how those allocations may overlap with other elements of your portfolio.