How Bond Funds Are Weathering the Storm

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Karen Wallace: Hi, I'm Karen Wallace for Morningstar. A lot of investors are seeing deep losses in the bond market, and they're wondering what's going on and whether they should be concerned. I'm here with Eric Jacobson. He's a senior analyst covering fixed-income strategies in our manager research group. He's here to help us make sense of it.

Eric, thanks so much for being here.

Eric Jacobson: Hi, Karen, glad to be with you.

Wallace: Eric, which bond market sectors have felt the most pain during this market downturn?

Jacobson: Well, as far as market sectors that have been hurt the most in the downturn, I think some of them are a little more obvious than others. For example, areas of the high-yield market including the energy sector have been decimated. But in terms of things that were a little more broadly held, including even in core and core-plus bond funds, a lot of the securitized subsectors have been hurt pretty badly.

We're talking here about CLOs, some nonagency mortgages, and essentially asset-backed type securities that are backed by more unusual things, auto loans and what have you. It's been a real issue because up until now, liquidity has been extremely difficult to find there. We've had a lot of mark-to-market pricing problems, even though the fundamentals of some of these things are probably going to be okay and they're probably going to pay off in the end.

Wallace: Have you seen any other performance trends that have surprised you?

Jacobson: I think one of the most surprising things going on has been performance problems in areas that are very high quality and normally don't feel that kind of pressure. As an example, the investment-grade corporate market just in the last few weeks has been hurt more than probably it ever has in such a short period of time. The standard investment-grade corporate bond indexes never had a single month anywhere near as bad as they've had in the last few weeks--more than 12% down.

Now, some of that's probably already on the way to coming back with all the remedial measures that the Fed and the Treasury have taken. But even Treasury bonds and agency mortgages were touched by this and had some problems over the last few weeks, though again, we're probably on the upside coming back a little bit.

Wallace: Eric, another word that people hear in the context of bond performance is liquidity. Why is liquidity so important for bond funds and how do Morningstar analysts assess the liquidity risks in a bond fund?

Jacobson: Liquidity in bond funds is just critical. It doesn't necessarily seem so under normal circumstances, but it's times like these that it matters because you can have such price volatility when liquidity ebbs in the market, and it's a real big problem if you happen to also have a lot of redemptions happening at the same time.

Morningstar analysts don't have a lot of hard numbers to work on for this. In part because the data itself is so scattered and difficult to measure, but also there are no really well-agreed-upon standards in academia or the industry to actually say, this is liquid and this isn't. We can talk about relative and trends and things like that, but a lot of it is more art than science.

We do a lot of talking to portfolio managers. We look at things that are somewhat predictive, like the size of issues, how high or low quality it is, what complexity is involved. By and large, if we see something that looks like it's going to be a fairly large block of bonds, for example, in a mutual fund that has the potential to be liquidity-challenged, it's going to be really hard for a fund like that to get a medal recommending it as a purchase.

Wallace: Eric, thank you so much for being here to help us put this in context and make sense of it.

Jacobson: I'm glad to help, Karen, thanks for having me.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.