Rate Hike Talk Not Deterring Bond Investors

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Tim Strauts. He is the senior markets research analyst here at Morningstar. We're going to look at May's asset-flow data and see what trends have been emerging.

Tim, thanks for joining me today.

Tim Strauts: Thanks for having me.

Glaser: Let's start with U.S. equity: more outflows out of active funds. This has been going on for some time. Anything interesting going on behind the scenes there?

Strauts: It's just the general pattern we've seen for the last year and a half. There was a negative $12.8 billion out of active U.S. equity and a small inflow of $1 billion into passive U.S. equity. This is a trend we've been seeing over the last few months, and what we really think is happening here is that people are taking money out of U.S. equity and moving it to international-equity funds.

Glaser: So, international funds did a little bit better. Where are people putting those bets? Is it emerging markets? Is it in Europe? What's been popular there?

Strauts: The two largest categories were foreign large blend, with about $14 billion in new inflows, and then European stock. In European stock, it's all been focused on the ETF side of the currency-hedged products, which we've talked about in the past because of the falling euro and the rising dollar. A lot of investors want to hedge the currency risk in this environment.

Glaser: Are there any risks, though, to that currency hedging? Do you think people are getting a false sense of security with those products?

Strauts: I think a lot of people are currency hedging their international exposure now when it's a little bit late in the game. The U.S. dollar has already risen 25% versus a lot of these currencies. You want to hedge your currency before the dollar rises, not after. So, if you're hedging now, you may be setting yourself for a fall here. Today, I think an unhedged position is probably the better value.

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Glaser: Let's take a look at the bond side. With the Fed looking set to raise rates later this year, have we seen an exodus out of these bond funds or are we still seeing inflows?

Strauts: Surprisingly, we saw pretty strong inflows this month. Taxable bond took in about $5.5 billion to $6 billion, and the largest foreign category was intermediate-term bond. Normally, when we see a rise in interest rates--which is what we had in the last month when the 10-year Treasury spiked, yields touched 2.5%--normally, when that happens, we see outflows out of intermediate-term bond. But that didn't happen.

And we think it could be because investors are seeing the U.S. equity market, where volatility is increasing, and they are saying, "U.S. equities are risky, bonds are risky, but bonds are less risky than stocks, so I'll put my money toward bonds."

Glaser: On the bond side, one thing you've been tracking are the flows out of PIMCO. What did that look like this month? Are there signs that they are slowing down?

Strauts: Yes. PIMCO, as a firm, lost $4.8 billion, and the Total Return fund (PTTRX) lost $2.6 billion. This would normally be a catastrophic loss for most firms, but for PIMCO this is actually an improvement. The numbers are getting better every month. We would expect, hopefully by the end of the year, that the negative flows will get back to break-even.

Glaser: Are all PIMCO funds seeing outflows or are there some that are doing a bit better?

Strauts: The one that is doing the best is PIMCO Income (PONAX). It took in about $1 billion last month. People seem to be using it as an alternative to Total Return, which may not necessarily be the best comparison; but on a three-year basis, PIMCO Income returned 9.9% versus Total Return, which only returned to 2.9%.

Glaser: Why shouldn't Income be thought of as an alternative?

Strauts: PIMCO Income is a multisector-bond fund, whereas Total Return is an intermediate-term bond fund. So, Income can have large allocations to emerging-markets debt, high yield, and nonagency mortgage securities. That's really where PIMCO Income has gotten strong its returns--through a very heavy mortgage allocation. It has done very well for them, but those portfolios with a lot of mortgage securities are riskier.

Glaser: How about any other fund families? Any notable flows there?

Strauts: Just one tidbit: Vanguard, for the first time in years, actually had an outflow from its active funds. Its passive funds still had strong inflows, but there was a small couple hundred million dollar outflow out of the active side.

Glaser: Tim, I appreciate your update on the asset-flow data for May.

Strauts: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.