Investors' Appetite Shifts to Riskier Bond Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Amid a skittish equity market, investors gravitated to bond funds in the first quarter of 2016. Joining me to discuss the latest fund flow data is Alina Lamy. She is a senior markets research analyst with Morningstar.

Alina, thank you so much for being here.

Alina Lamy: Hi, Christine. Thank you for having me.

Benz: Let's discuss these ongoing flows into bond funds. We saw a pretty pronounced trend during the first quarter. What do you think investors were responding to? We did have that equity market volatility in January and the first half of February. Would you say that was it?

Lamy: There was that big sell-off in January and I think investors got a little bit scared, a little bit more than a little bit scared. We saw significant inflows into gold, precious metals, the SPDR Gold ETF in January and February. So, that was a little bit--I don't want to say a flight to safety--but there was a little bit of a fright there. But then as the market rebounded in February and March, investors went into taxable bond funds. That was the highest-receiving category for the quarter, with $36.6 billion, by far.

Benz: So, you kind of see it as a tale of two markets in the first quarter where investors were preferring maybe some of the more defensive bond funds initially but then later on in the quarter you say that it looks like they were gravitating to some of the higher-risk bond funds. So, let's discuss that bifurcation.

Lamy: Most of the inflows went into intermediate-term bond funds, which makes sense because they are kind of the middle of the road, moderate risk, moderate duration risk.

Benz: Right.

Lamy: However, it was a little bit surprising to see very high flows into high-yield bonds as well. There was the Third Avenue scare in December that prompted big outflows from the high-yield bond category.

Benz: So, let's just talk about that. That was a fund that ran into problems and ran into liquidity problems and got investors pretty nervous about the high-yield market in general.

Lamy: Exactly. It took a lot of risk that it wasn't supposed to be taking and investors got very scared. They couldn't redeem their money anymore basically. But that was only one fund. But usually when something like that happens, the scare reverberates through the entire category, and that resulted in big outflows from that fund and other high-yield funds as well.

There were outflows in January as well, but in February we saw inflows and in March, we saw the highest inflows for the high-yield category since October 2011. So, that is showing us a few things, that investors got over the Third Avenue scare pretty quickly and that they are desperate for yield. So, no matter how scared they were about the higher risk of high-yield bonds, they chose to go back to them and search for that higher yield.

Benz: And yields did get more attractive, right, when high yield sold off in January, first half of February? We did see yields pick up to a level that we haven't seen for at least a year or two now.

Lamy: Exactly and that got reflected in the flows.

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Benz: Let's talk about corporate credit funds. Those are generally high-quality corporate-focused funds. Those too saw inflows, correct?

Lamy: Those too saw inflows and again, mostly in the intermediate-term space with those with the corporate specifics you are taking on the additional credit risk in addition to the interest-rate risk. So, they saw slower inflows, smaller inflows than the general intermediate-term bond category but they did see inflows as well. So, again, higher acceptance of a little bit more risk in exchange for higher return.

Benz: You noted in your report that one category that bucked the trend in terms of taxable bond fund flows was this nontraditional bond category. Let's talk about it. These funds were so hot a few years back, investors and advisors were buying them pretty avidly but they seem to have pulled back recently. What do you think has driven that change in sentiment?

Lamy: So, nontraditional bond funds are all about hedging the risk of rising interest rates. They can short bonds, they can employ all these strategies that traditional bonds cannot do. So, that's why they were so attractive at the beginning because investors foresaw rising interest rates and thought these bonds are going to--these funds are going to protect me from that. But that didn't happen; rates didn't rise as fast and they almost didn't rise at all. So, investors kind of lost patience with these funds and also, the big issue here is that no manager can time that correctly. Nobody can actually say exactly when and by how much interest rates are going to rise. So that's why these funds lost part of their appeal, and we didn't see as many inflows going to them.

Benz: I know that you and the team have been monitoring this ongoing trend toward passive products. One thing that perhaps we haven't talked as much has been the fact that investors have also been buying passive bond funds and that's something that you saw very clearly during the first quarter. Let's talk about that, and why you think we're seeing such strong flows into passively managed bond products.

Lamy: That definitely happened. The majority of these flows we've seen in the taxable bond funds went into passively managed funds. And the passive trend, the indexing trend started in equities a long time ago and it first started in the large equities, in the large equity space. We index large cap very much. And then it started extending to other types of equities, to mid-cap, small caps and then after that we indexed the entire market and then we indexed international stocks and it slowly, slowly, started extending to other asset classes. So, now, it's becoming more prevalent in the fixed-income space as well, especially since the taper tantrum of 2013 we've seen a clear shift in investors' preference and now most of the inflows are going into passively managed bond funds.

Benz: Let's talk about the equity side briefly. The big story has really been what's been going on with bond fund flows, but what are you seeing on the equity side? I assume you're continuing to see outflows from the actively managed fund categories and investors continuing to swap into passive there, too?

Lamy: In the U.S. equity funds--exactly--not much has changed. There are some inflows into passively managed U.S. equity funds and outflows on the active side, significant outflows. With the international equity, the picture is different from what we were seeing a year ago. A year ago we had massive flows into international equity funds and investors were diversifying a lot within that space. There are still inflows into international equity right now but not as significant as they were a year ago. In fact, now flows are much better distributed among all asset classes. It seems like they are more balanced. There is no clear dominant trend like international equities were a year ago.

Benz: Looking at the fund family view, not surprisingly given what you've just said about the ongoing preference for passive products, some of the passive providers seem to be really cleaning up in the fund flow sweepstakes. So, whether it's Vanguard or iShares, or State Street, those firms have really been doing the best in terms of garnering new flows, right?

Lamy: Yes, they have. Vanguard obviously has been the leader in March. Actually, this company gathered inflows larger than the rest of the market combined.

Benz: So, relative to all of the other fund providers their gains were larger?

Lamy: All of the other fund providers, exactly. iShares is able to compete pretty well though. State Street and also DFA in the passive space, but the leader is clearly Vanguard. And also, on the active side, in March, in my report I have a list of the top flowing funds, the funds that received the highest inflows on the active side and on the passive side. And usually, on the passive side, I see Vanguard, Vanguard, Vanguard, OK, that's OK. But this past month in March, I saw Vanguard top the active list as well with its Vanguard Intermediate-Term Investment-Grade Bond Fund. So, an active Vanguard fund was the highest-receiving fund among all other active funds.

Benz: Another story I want to touch on is American Funds. This had been kind of the poster child for an actively focused firm seeing redemptions. But it seems to have turned things around to the point where flows into American Funds have been positive, not just in the very recent past but over the past year as well.

Lamy: They have been doing pretty well. They have a multi-manager model. It's the way they manage their funds. And they've been doing pretty well. For example, their American Funds American Balanced Fund, their performance has been really, really good over the past year. They have been in the [second] percentile of their category, so outperforming 98% of the other funds in that category, and that was reflected in the flows. That fund has attracted a significant amount of flows recently. Another of their funds that has been doing well and performing well is American Funds Europacific Growth and that goes into that diversifying into the international equity trend that we've seen and for American Funds it was this fund that attracted some of those inflows.

Benz: Alina, it's always fascinating to look at investor choices, look at investor fund flows. Thank you so much for being here to discuss the data with us.

Lamy: Thank you, Christine.

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