Why Do Investors Keep Buying Bond Funds?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The Federal Reserve boosted interest rates in the first quarter of 2017, but investors continue to buy bond funds. Joining me to discuss the latest fund flow data is Alina Lamy. She is a senior analyst with Morningstar.

Alina, thank you so much for being here.

Alina Lamy: Hi, Christine. Great to be here.

Benz: Let's talk about this. Rates going up, that's usually bad for bond prices, but yet we've seen this trend of investors sending dollars to taxable bond funds, municipal bond funds to a lesser extent. Investors don't seem overly spooked by the prospect of higher rates.

Lamy: It's interesting. It's a little bit counterintuitive when you look at it first, because as you said bonds don't do that well in a rising interest-rate environment. However, there are other benefits to bonds that investors seem to be going for. First is diversification. They are always good to diversify a stock portfolio. And then there is the income. Even if the price of a bond will go down when interest rates rise, there is also that guaranteed income stream that investors can count on. So, from that point of view, they are still a very valuable asset class.

Benz: And with rising yields, higher yields coming online, maybe investors are attracted to that idea of being able to pick up a slightly higher payout from their bond funds.

Lamy: Exactly. When the new bonds are issued, there would be higher coupon rates that's going to counter the effect on the old bonds.

Benz: Right. When you look at specific categories that have been seeing flows in the bond-fund realm, intermediate-term bond looks like the place to be, the big core-type products that appears to be where investors are sending their dollars.

Lamy: Exactly. And that makes sense because intermediate-term, they are less sensitive to interest rates than their long-term counterparts. And on the other hand, shorter-term bonds, they don't offer that much of a return. So, intermediate-term is kind of the middle of the road, a sensible solution for most investors.

Benz: OK. In terms of the active versus passive split, I know this is something that we have been monitoring, you've been monitoring on the equity side, very strong pronounced flows toward passive products. With bonds, it looks to be a little bit more evenly split. Investors are certainly buying some passive products but also buying some active.

Lamy: It's very interesting, exactly. In the fixed-income territory, active funds have still seen significant inflows and especially in the last month, in March, intermediate-term bond funds, active flows were higher than passive flows. So, it seems that investors are still putting their confidence in active fixed-income managers, that they are able to navigate this uncertain bond fixed-income environment with interest rates rising and everything else that's going on. It seems that managing a fixed-income fund, being able to pick the right bonds--there are a lot of bonds out there, way more than stocks--and the skill of a manager to pick the right bonds and to construct a reasonable--with the reasonable risk and higher return, hopefully, portfolio that's valued by investors because that's where they are putting their money.

Benz: OK. Let's talk about equity. The interesting thing there to me at least is that international equity has received more flows than domestic equity recently. That's true whether you're looking at active or passive, that international equity appears to be the place to be. Emerging-markets also appears to be generating pretty good flows. What's your thesis on what's going on there?

Lamy: In terms of international equity in general, developed markets, a large part of the flows has gone into foreign large blend which is mostly Europe. And Europe has done pretty well. In the first quarter, it's about 7% return. So, it can be that flows are following those returns. It's also a question of diversification. And in terms of that let me move back a little bit and talk about U.S equity a little bit.

There has been a reversal since the election in flows. It's pretty impressive. Before, for the past year, U.S. equity was in outflow territory. But after the election, there was a resurgence, and U.S. equity flows have more confidence that the new administration would implement tax cuts, deregulation, and that will create a business-friendly environment. And returns followed. The S&P was up 12% almost since the election until the end of the first quarter. So, strong confidence in the U.S. market.

And in addition to that, going back to your question for the international market stock returns there, and the flows seemed more balanced. In the first quarter, it's literally positive flows to U.S. equity then international equity and then the majority into taxable bonds. But overall, even though taxable bond flows are dominating, the flows overall seem more diversified. Diversified with a stronger fixed-income component.

Benz: OK. One area where they are not at all diversified is this active versus passive split on the equity side that we are seeing very pronounced flows toward passive products, correct?

Lamy: Correct. That did not change.

Benz: No. And that informs some of the fund family winners and losers when it comes to these asset flow sweepstakes. When you look at the firms that have been seeing the biggest inflows, it's Vanguard, it's BlackRock with its iShares passive lineup. They've really been eating everyone else's lunch.

Lamy: They have been dominating. Vanguard first and BlackRock has done really well in the passive territory with their iShares unit as well. But something very interesting is happening so far this year in the first quarter. Before when you looked at Vanguard versus the rest of the world, Vanguard for the past two years had positive flows and the rest of the world was in negative territory.

So far, this year, Vanguard is still leading by a huge margin, and they are in positive territory. However, the rest of the world is positive again as well. So, there's some hope for everybody who is not Vanguard. They did have inflows as opposed to outflows in the first quarter.

Benz: OK. One thing I want to touch on with you, Alina, is the repercussions of these outflows from some of the active shops. Even though some of them have moderated a little bit, that there have been layoffs at some of these firms. So, there have been repercussions for personnel. Firms are skinning down their staffs a little bit.

Lamy: The most recent news, the big news in March was BlackRock, who decided to revamp their active equity strategies. They are going to use more quantitative computer-driven models, and that was restructuring of their active equity management unit and there were companywide layoffs including a few portfolio managers. So, it will be interesting to see if replacing humans with computers, because that's basically what they are doing, it will be interesting to see how that plays out going forward.

Benz: OK. Another firm I want to touch on is PIMCO. The firm, I know, we had all been watching. After Bill Gross' departure a few years ago, Total Return have been seeing month after month of outflows. PIMCO now is gathering assets again, not so much in Total Return, but in PIMCO Income. Let's talk about what's going on there.

Lamy: PIMCO Income has been on the top flowing list for most of the months in recent years, and I think it's pretty remarkable the way they handled their outflows from Total Return after Bill Gross left. That was a huge strain on the firm. They had so many redemptions, and they handled that beautifully. On the other side, they were able to garner inflows with PIMCO Income and still managed their portfolios in order to meet all those redemptions. So, again, I think it's a remarkable story, and they were able to turn around in March.

Actually, the first time--usually, the irony is that Vanguard gets higher inflows on the active side than all the companies who are actually specialized on the active management side. However, in March PIMCO was able to get higher active inflows than Vanguard and most of them went into PIMCO Income. It's funny that we got to this point, but it's the month where one active company did get the highest active inflows. And they have quality management. They are experts in fixed-income management. And it makes sense that they have this investor confidence, and they are able to keep getting inflows.

Benz: OK. Alina, thank you so much for being here to discuss the intersection between investor behavior and fund families, and which are getting the inflows. Thank you so much for being there.

Lamy: Thank you, Christine.

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