Bond Funds Bring It on Home

There's been much discussion of bond-fund managers increasingly investing beyond the confines of the high-grade U.S. bond market in recent years. That seems intuitive: Yields on high-quality U.S. bonds have plumbed new lows, pushing investors into relatively higher-yielding sectors, such as emerging-markets bonds, junk corporates, and nonagency mortgages. Prominent managers such as PIMCO's Bill Gross have also made widely telegraphed moves in this direction, particularly in diversifying among "clean dirty shirt" developed and emerging sovereigns. And as my colleague Eric Jacobson noted previously, correlations between actively managed bond funds and the Aggregate index have been on the decline since 2008's credit crisis.

While some core bond funds are certainly following the prompting of the Federal Reserve (and the Bank of Japan, the European Central Bank, and the Bank of England) into riskier territory, the trend may be overstated. For one, correlations between certain bond sectors and the Aggregate index--including investment-grade corporates and agency mortgages, which make up close to half the index combined--have themselves declined in recent years, while the index's correlation with Treasuries has risen. That partly reflects the changing composition of the Aggregate index, as the Treasury department's bond issuance has outpaced that of other eligible sectors. Treasuries currently account for 36% of the index, up significantly from just 22% at the end of 2007.

Given those dynamics, active bond funds could have seen their returns deviate from the index's to a larger degree in recent years without making dramatic changes to the composition of their portfolios. Also, there are signs that valuations on some non-Treasury sectors are starting to look less attractive, particularly now that a significant portion of their yield advantage has eroded over the past year. At the beginning of 2012, for instance, high-yield corporates, having been battered about by fears of a eurozone crisis contagion, offered an additional 750 basis points in yield over Treasuries, on average, which made them cheap relative to historical norms. By early May, though, that gap has narrowed to just 400 basis points, while the sector's average absolute yield has reached record lows of around 5%. For funds that stick with the investment-grade arena, the debt of large financial firms has been a popular bet for similar reasons. But since the start of 2011, the yield spread on the financials sector has dropped to 130 basis points from nearly 350.

For several noteworthy bond managers, price moves like these have given them reason to begin cutting back their exposure to non-Treasury areas.  For instance, while the team at  Metropolitan West Total Return Bond (MWTRX) still has plenty of out-of-index exposure to the nonagency mortgage market, the fund's Treasury stake had more than doubled over the past 12 months to 27% as of Dec. 31. The fund's overall corporate credit exposure meanwhile (including investment-grade and high-yield) has been reduced from roughly neutral relative to the index to a 5-percentage-point underweighting. Fidelity's investment-grade bond team has similarly been cutting back on credit risk;  Fidelity Total Bond (FTBFX) typically holds a strategic allocation to high-yield and emerging-markets bonds (currently 13% combined), but its Treasury stake climbed to 28% as of March 31, 2013. Even the venturesome  PIMCO Total Return (PTTRX) was getting roughly half its portfolio's duration from Treasuries as of late.

The examples of managers pulling in the reins as valuations have ground tighter go on. That doesn't mean investors shouldn't be on the lookout for ways their fund may be branching out, particularly in areas such as currencies, esoteric structured securities, and highly credit-sensitive bonds, where small exposures can really pack a punch. But some bond managers' decisions to play it relatively safe, even if that means shifting assets into a sector that many agree offers little to no long-term value at current monetary-policy-elevated prices, should help inform investors' expectations for what kind of performance they can expect out of their bond funds. Even favorite sectors of fund investors over the past several months--including emerging-markets bond and high-yield funds--may not offer the antidote to today's low yields that some would hope. 

A version of this article appeared in the May 2013 edition of Morningstar FundInvestor.