Who Won, or Lost, in the Bond Fund Sell-Off

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Tom Lauricella: For Morningstar, I'm Tom Lauricella, and I'm happy to be speaking to Eric Jacobson today about the bond market terminal that we saw back in March and April, and how that affected which funds were the winners during this time of turbulence and which funds were the losers.

Eric, welcome.

Eric Jacobson: Thanks Tom. Good to be with you.

Lauricella: Why don't we start by first just recapping the two stages of the bond market that we saw in March and then in April. It was really kind of a before-and-after story. What was the dynamic?

Jacobson: Yeah, it's really interesting because to a large degree it's all been based on fear rather than actual data, right? So once things really kicked off around February 20th and you saw the equity markets tumble and suddenly everyone in the bond market was scrambling. What I mean by that is there was a need--because of the fear and to some degree, because of what was going on in the equity market, investors were dumping everything to try and raise cash, or using cash for this or that, and pulling it out of portfolios. Whatever it was, cash was the king and that even affected markets as usually liquid, and unbelievably so, as the Treasury market. So it really rippled through the entire bond market.

Lauricella: And so that fear that you were talking about it, also rippled through to the credit markets as investors became very worried about the economic impact. How did that play out for bond funds?

Jacobson: Right. So it was really a double whammy. On the one hand, the initial wave of fear was liquidity-driven. Everything just sort of froze up. Concurrent with that, all of a sudden we started having that credit fear. In other words, we started out with a liquidity crisis. It hadn't yet become a solvency question, but once it started to look like we could go for quite a while and companies could actually go belly up and so forth, then anything that had a real even whiff of credit risk--and especially things like high yield and bank loans and so forth, they really took it on the chin.

Lauricella: And then we had that very sharp reversal starting in late March. What happened there?

Jacobson: So as you know, we've never seen anything like it in terms of government response. It started with the Fed and it just kept going, so that the Fed committed to pumping more than $2 trillion into the system. Initially, a lot of that was really targeted just to keep liquidity up, but they started rolling out additional programs. We had fiscal involvement. In other words, Congress and the Treasury got involved actually spending money, not just pumping it into the system like the Fed does. And at some point the message got through to the market that "We're going to do everything we can to keep the system going." Now that didn't assure everybody about the economy, and areas of the credit markets were still under a lot of pressure and still are today to some degree, but it did have something that a lot of managers refer to as sort of putting an umbrella over the market and managers want to get under that umbrella and own assets that the Fed in particular is going to support.

Lauricella: So the Fed is actually going into the bond market and buying securities. Right?

Jacobson: So what's interesting about that is, the answer is yes. And it is similar in some ways to the quantitative easing that we've had over the last several years where they were buying mortgage-backed securities, and Treasuries, and so forth. And they have in fact expanded that palette quite a bit. What's interesting about it is there are a lot of areas we haven't quite seen them doing a lot of buying yet, but all it really took was the initial declaration that they're going to buy to get investors under that umbrella that I talked about earlier, where they're like, "Okay, we can buy this stuff now because we know the Fed's going to be there to support it."

Lauricella: So what did that mean in terms of what worked and didn't work for bond fund strategies during these two periods?

Jacobson: Right. So initially nothing worked right in terms of the sell-off. Eventually it made a big difference to have more rate-sensitive Treasury bonds and so forth. You may recall we had a very sharp rally in intermediate and longer-term bonds as yields across the yield curve went down under 1%, and then things that fell out of bed amazingly enough, in some ways, were things like securitized instruments that had AAA ratings, but about which the market might be concerned about liquidity. And in some cases, things that would have a ripple effect from credit problems underneath as well. As far as the rebound is concerned, most of that stuff snapped back that had gotten marked down very strongly. And what's important and interesting here is we are even talking about really high-quality investment-grade stuff, and certainly things with high ratings, corporate bonds, and so forth.

Jacobson: On the other end of it, things that didn't snap back as well generally had to do with energy. As you know, we had a huge sell-off in oil prices and fears about energy companies going out of business right away and so forth. And then you also had one area of the market that was kind of interesting, called credit risk transfer securities, which are a new kind of mortgage-backed security that were designed to take risk off the books of the big mortgage agencies, such as Fannie Mae and Freddie Mac, and sell them to investors for a bunch of reasons, including what we call the thinness of the tranches. In other words, they're not that big and the lower spot that they take up in the capital structure, so they're riskier.

Investors got really scared about those. They dumped them. And it also so happened that there were some big non-mutual fund investors, mortgage REITs, and so forth who had lots and lots of this stuff. And when they started dumping it, that didn't help either.

Lauricella: So let's look at two examples of funds, one that weathered this up and down very well and one that didn't, starting with the Carillon Reams Fund. Folks might not know that name, but it's an interesting fund. Why don't you tell us a little bit about how does their strategy manage to do so well during this period?

Jacobson: So the Carillon Reams Fund that we've been talking about, Tom, is very tactically oriented. They wouldn't describe it that way, and I guess there's some nuance to that. When I say tactically, I mean that they're willing to move very quickly, strategically if you will. And their overall process is to not hold things that they think are rich in valuation. And so coming into the crisis, they did not have a lot of credit risk. They had a very generic portfolio compared with sort of the broad investment-grade bond market. And that helped a lot--they did not get taken down very badly by the sell-off, and then as soon as things got cheap and they looked to the point where they were so cheap they had to buy, they did it very, very quickly. They bounced back quite a bit on the other side. That's pretty unusual to sort of hit that mark that well and that easily.

Lauricella: Another fund we discussed was a Guggenheim offering. This is a fund that did very poorly last year, but managed to do very well during the market turmoil, what happened there?

Jacobson: So the Guggenheim story is very interesting because it certainly affected their flagship total return fund, but they did a lot of the same things across their portfolios. And what that meant was that going across 2019--and in fact, this really started late in 2017, and with some serious changes late in 2018--they took a lot of risk off the table. They saw valuations become too high for their taste with pretty much any kind of credit-sensitive issues. So they were really, really low on risk coming out of 2019. And what was interesting is they didn't capitulate to that. That's the thing we always worry about is that a manager is going to ride that through, feel the pain of those falling behind, and then feel compelled to finally jump in and take risk at just the wrong time. And we've seen that over the years before, and they did not do that.

So they did really, really well during the sell-off. I'm sure that they started to add back some risk since then to some degree. I don't know how much, I don't think it was very much. I think they're probably still pretty cautious and conservative, so I don't expect it was a lot, like some managers. But the fact that they stuck with it and the fact that they protected investors so well, and now for the year to date, and even just since the crisis started, they're doing as well as anybody. They're real near the top of the group in their big funds.

Lauricella: Okay. So let's talk a little bit about some fund strategies that did not do so well. Generally we saw some number of funds at Putnam and Pioneer that were hit really hard and then didn't recover very much. What was the story there?

Jacobson: Yeah. So it's interesting, I'd mentioned earlier something about CRTs, credit risk transfer securities. And so again, they fell out of bed pretty badly. These are agency-issued securities, but they're not backed by the agencies the way other things are with a AAA rating. These securities are designed to lay risk off of the agencies and give it to investors. And not only are they relatively new and investors worried about them because of these various issues with the securities themselves, but they were widely held among certain private investors, especially, but also a couple of very big mutual funds, if you will. They were held in large size by a couple of mutual funds, not necessarily huge mutual funds. And when investors had to dump them, in some cases, some of these private funds in particular, they just got taken to the woodshed if you will. And other investors didn't want to pick them up and buy them. So they have not bounced back nearly as well.

Lauricella: Got it. So when you pull all this together, what are some lessons for bond fund investors going forward from this really extraordinary period that we've been through?

Jacobson: Well, one of the lessons that I try to focus on, and this was really true during the financial crisis, it wasn't as high-profile in this case, but what I'm talking about here is willingness to take some interest-rate sensitivity in your portfolio regardless of what's happening in the marketplace and look at it as an insurance policy. And what I mean by that is, and especially now, we have such low yields that it's really hard to imagine Treasury bonds having any lower yields on any higher prices. So I think a lot of investors normally would say, "Well, why would I even want to own those?"

The fact of the matter is, is that when there is a crisis, people do go to Treasuries. They didn't rally very well right at the beginning of this crisis because of the liquidity issues, but eventually they did. And that was probably one of the very few things that worked in anybody's bond portfolio. And so what I'm trying to say is you have to be willing to look at that element of your portfolio during good times when your stocks are rallying and everything else is doing well and say, "Hey, it's not doing anything here, but that's my insurance." And if you're fortunate enough to have it set up well, that's what's going to save you or at least soften the blow when everything else goes to hell later on in a bad crisis like we had here.

Lauricella: Great, Eric, thanks very much for being with us.

Jacobson: Glad to be with you. Thanks for having me.