The Year in Bond Funds

"Prediction is very difficult, especially about the future." –- Niels Bohr.

Coming into 2014, prognosticators had the fixed-income markets all figured out. Many posited that it would be a rough year for U.S. Treasuries and other rate-sensitive bonds as the Fed unwound its bond-buying program. Meanwhile, riskier assets, including junk bonds and bank loans, seemed poised to outperform against the backdrop of manageable corporate-debt levels, decent economic growth, and strong investor appetite. Munis were a trouble spot amid bad news out of Detroit and Puerto Rico, while many thought of Russia as a relatively high-quality name in the emerging-markets arena. Finally, Bill Gross was still synonymous with  PIMCO Total Return (PTTRX), which, despite some outflows the previous year, was sitting on net assets of close to $240 billion.

It's fair to say that script played out differently. Below we recap several of the biggest stories in bond fund land from 2014.

The PIMCO Saga and the Reshuffling of the Intermediate-Term Bond Category
Bill Gross' departure from PIMCO and from the helm of the once-largest fund in the world was one of the biggest fixed-income stories of the year. While the fund's outflows continued at a hefty pace through November, there are encouraging signs that things are stabilizing at PIMCO. Significant investment staff departures have yet to materialize, while several key contributors who left the firm in recent years have returned. The current leadership team seems energized despite outflows. Perhaps more importantly, while PIMCO Total Return is lagging the Barclays U.S. Aggregate Bond Index since Gross left, it is doing a bit better than its intermediate-term bond peers, providing some comfort that redemptions aren't taking a significant toll on performance. Morningstar downgraded the fund's Analyst Rating to Bronze from Gold following Gross' exit to reflect the uncertainty associated with its transition to a multimanager-run fund in a post-Gross world. However, that Bronze rating also reflects the unparalleled depth of PIMCO's investment resources.

Gross' departure had implications well-beyond PIMCO's headquarters in Newport Beach, California. Bond managers have scrambled to take their share of PIMCO's massive outflows. Within the intermediate-term bond Morningstar Category, the home to most core bond funds, Vanguard has been a biggest winner, with estimated net inflows to index juggernaut  Vanguard Total Bond Market Index (VBMFX) of $19 billion for the year to date through November.  Metropolitan West Total Return (MWTIX) has also seen substantial flows ($17 billion) as have  Dodge & Cox Income (DODIX) ($11 billion), Fidelity ($8 billion across several funds), and  DoubleLine Total Return (DBLTX) ($6 billion). 

An Unanticipated Bond Rally
Turning to the markets, 2014 showed once again how hard it is for fixed-income managers to get interest-rate bets right, especially in the short term. Against the backdrop of geopolitical risk, a softer-than-expected global economic outlook, and pension fund rebalancing, long U.S. Treasuries enjoyed an unexpectedly strong rally. By Dec. 18, the 10-year U.S. Treasury yield stood at 2.20%, down from 3.04% at year-end 2013. The 30-year enjoyed an even more impressive run. Long Treasuries were the best-performing part of the market through mid-December, catching many core managers, who had positioned their funds for an increase in bond yields, flat-footed. However, some, including the team at Silver-rated  Western Asset Core Plus Bond (WACPX), benefited from a decision to favor longer-maturity bonds. The rally was much more muted in shorter maturities, and the yield on the three-year Treasury actually increased over the course of the year, reflecting in part the expectation that the Fed will start to raise short-term rates, however gradually, sometime in 2015.

The rally in long investment-grade bonds has helped propel the Aggregate Index to a 5.6% return for the year through Dec. 18. All sectors enjoyed solid gains, with midquality corporates a particularly strong performer. For the first time since 2011, active funds in the intermediate-term bond category have had a difficult time beating this bogy, with roughly three quarters of the universe lagging the broad benchmark year to date.

Junk Bonds in Trouble
After starting the year strong, things turned ugly for high-yield bonds in the second half of the year. Although it was hard to pinpoint exactly what drove the category's periodic sell-offs that started in June, the asset class' more recent troubles stem in large part from struggles in the energy sector. Energy companies, driven by a surge in shale-oil drilling, had issued a ton of cheaply priced debt in recent years' borrower-friendly high-yield markets and had grown to become the largest sector in the high-yield market, accounting for roughly 13% of the Bank of America Merrill Lynch Master II Index as of mid-December. With oil prices plummeting below $60 per barrel, energy-related high-yield names got slammed, resulting in a 3% loss for Morningstar's high-yield bond category for the first two weeks of December. All in all, the category is on pace for its worst year since 2008 with a number of funds now sporting losses for the year to date. Funds with sizable energy stakes, such as  Franklin High Income (FHAIX) have, not surprisingly, been hit the worst, while some more adventurous funds with meaningful equity stakes, including  Fidelity Capital & Income (FAGIX), are still well into positive territory.

Other credit-sensitive categories have also languished in 2014. The average return for Morningstar's bank-loan category was a positive if anemic 0.2% for the year to date. Meanwhile, the nontraditional bond category, which has seen assets more than double since the beginning of 2013, was up just shy of 1% for the year. Both categories have minimal exposure to the Treasury rally and tend to court plenty of credit risk.

Challenges Abroad
With conflict between Russia and Ukraine dominating headlines for much of the year and the recent plunge in energy prices, there were plenty of potholes to avoid in global bond markets. The situation intensified in the first weeks of December as the ruble tanked and Russian sovereign debt took a sharp tumble. Funds such as  PIMCO Emerging Markets Bond (PEBIX), which as of November 2014 sported a 21% Russian stake, have suffered particularly steep losses. Meanwhile, a decisive rally in the dollar against almost all major currencies meant trouble for funds with meaningful exposure to nondollar currencies. That led to a particularly wide spread in returns for funds in Morningstar's world-bond category, with funds sporting gains of up to 15% and losses as steep as 5%.  Templeton Global Bond (TPINX), which sports stakes in Ukraine, Russia (albeit small), and Poland, among others, landed near the world-bond category midpoint with a 1.4% year-to-date gain.

Muni Rebound
Munis were one of the hardest hit sectors in 2013, thanks in part to a run of bad headlines out of Detroit and Puerto Rico. The recovery in Treasury yields kept the muni market in good stead in 2014, however. Supply remained relatively muted while Morningstar's muni-bond categories enjoyed $25 billion in net inflows for the year through November, providing a supportive technical environment for the sector. Meanwhile, headline risk faded as Detroit exited bankruptcy and many municipalities saw improving finances. Even Puerto Rico, whose fate is far from clear given the territory's cash-strapped fiscal state and continued economic stress, saw a rally in its bonds. Funds that take on more credit risk--including the intrepid  Wells Fargo Advantage Municipal Bond (WMFAX)--fared particularly well, as did high-yield muni funds that avoided the struggles faced by their taxable cousins. The average fund in Morningstar's high-yield muni category has notched a 13.5% gain for the year.