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Bonds Defy Naysayers Again in the First Quarter

Christine Benz
Sarah Bush

Christine Benz: Hi, I'm Christine Benz from Bonds continue to defy the naysayers in the first quarter of 2016. Joining me to provide a recap of the first quarter for bond funds is Sarah Bush. She's director of fixed-income strategies in Morningstar's manager research group. Sarah, thank you so much for being here.

Sarah Bush: Thanks for having me, Christine.

Benz: Sarah, a lot of hand-wringing going on about bonds and bond funds over the past several years, really five years now. Bonds, bond funds logged a pretty good quarter in 2016. Looks like if you were long duration, that was really the place to be for the quarter.

Bush: That's absolutely right. We saw just a really strong rally actually across the yield curve for Treasuries, but long-term Treasuries are one of the top performers for the quarter to date. A lot of that was in January and February. March wasn't as strong a month because we did see a little bit of a rebound in risk assets. So in terms of what's going on there, people are certainly paying very close attention to the Fed; we've seen some more dovish statements come out of the Fed, so I think the expectation is maybe one or, at most, two Fed hikes this year. I think the other piece of context that's important, though, to understanding what's happening with longer-term maturity Treasuries, is that we've had very, very loose monetary policy globally, and you're looking at superlow or even negative rates abroad, and that definitely has an effect on the Treasury yield curve.

Benz: OK. I want to talk a little bit about Treasury Inflation Protected Securities because this has been kind of a deeply unloved fixed-income asset class for a while now. Nobody has been concerned about inflation at all, and yet TIPS had a pretty good quarter. What's going on there?

Bush: They did, and as you point out, that's actually been a difficult market for a while. So one of the things we've seen, there's this measure called break-even inflation rates, which is basically the point at which you're indifferent between holding TIPS with the inflation protection and Treasuries. That's been coming down and very very low, and that started to edge up a little bit over the quarters. So couple of things are driving that. One, we have seen some positive some signs on the inflation front, or increases in inflation. So energy prices have stabilized, they're starting to climb a little bit. We've also seen core inflation in the US coming up a little bit. So that's definitely a good thing for TIPS and funds that hold them. The other piece of the equation I think again is just going back to the Fed and the expectation that if real rates remain low, that's a good thing for TIPS.

Benz: Okay. I want to talk a little bit about some of the more credit-sensitive bond types, you mentioned that they recovered, they were pretty beaten-down in the early innings of 2016 when we had all that equity market volatility, but they staged a recovery. Let's talk about what's going on there, and why investors seem to be a little more sanguine about credit risk and some of their credit-sensitive bond types have performed OK.

Bush: Right, we saw a pretty strong rebound in high yield mostly in March. I think again, a couple of things are driving that. We talked about energy prices, there's a lot of energy and other commodity-exposed credits in the high-yield market--that's definitely been a positive. I think the thing to keep in mind there, though, is that default rates could still be pretty high. They've been on an upward march. I think a lot of people expect that to continue for a couple of years, in the metals and mining and the energy space. And when you look at yields in that space, they look pretty attractive, but a lot of that is coming from, again, the energy and commodity-related sectors where there still is a lot of trouble. So, we're hearing managers starting to pick through that, or picking through that for the last year, and I think they are finding some opportunities. But you've got to be careful because those energy names could still cause a lot of trouble.

Benz: Okay. I wanna talk a little bit about some of the non-dollar bonds, because the performance was OK there as well. I'd like to drill into what's going on there. Emerging-markets bond funds had a decent quarter, maybe syncing up with sort of that, risk-on sort of mentality that prevailed in the later part of the quarter. But let's talk about non-dollar bonds and what you think is driving the strength there.

Bush: And again, non-dollar was a part of the market that really had a rough 2015. So some of that, if you look at it over the full period, they're still down quite a bit. But we have seen a rebound in a lot of currencies in emerging markets in particular. A lot of those are the currencies that were hardest hit last year; obviously improvements in energy prices are a positive for some of those emerging markets. I guess the other thing is it's a little hard to read the tea leaves on currencies, but to the extent that the Fed is a little bit more dovish than was expected, that could also be something that would contribute a little bit to dollar weakness.

Benz: Okay. Can you touch on the muni market and what's been going on there?

Bush: So, again, actually the muni market is interesting because last year high-yield munis did pretty well, so a little bit of a flip from what you saw on the taxable markets. That's continued into this year, so high-yield muni categories are doing better basically across the board. And actually we've seen spreads kind of valuations there starting to get a little bit tight...

Benz: Meaning they would be less attractive...

Bush: Meaning they'd be, right, from a valuation perspective they'd be less attractive. So, and then if you kind of look more broadly at the muni market, a lot of times it could be driven by technicals and what inflows and outflows look like, and flows have been fairly strong. And credit, there are a few names out there of people are certainly worried about--Puerto Rico, here in Chicago, Illinois.

Benz: Right.

Bush: We all talk about that a lot. But beyond that, I think there's generally a sense that muni credit remains pretty strong.

Benz: The fundamentals for the muni market are pretty strong...

Bush: Right, right.

Benz: OK. Let's talk about some of the biggest funds, some of the most highly rated funds from the analyst team. I usually like to cycle through how they've performed. Can we start with some of the credit-sensitive core funds? You mentioned that they've actually performed really well, but they had a terrible 2015.

Bush: Right. So Loomis Sayles had kind of a rough year across the board and that was both about credit and also about currency, which is an exposure in a lot those funds. So if you look at the intermediate-term bond category, Loomis Sayles Investment Grade, which is a very credit-sensitive fund, that's one of the top performers year to date in terms of our Medalists. Their Core Plus fund is also doing pretty well.

Benz: OK. MetWest Total Return, one of the big beneficiaries of Bill Gross leaving PIMCO, saw a lot of asset inflows. Let's talk about what's been going on there, and maybe Dodge & Cox Income, too, which was another PIMCO beneficiary.

Bush: Right, so both of those are kind middle-of-the-pack here today to lagging a little bit. Those are both shops that have had kind of bearish, conservative view on durations, so the fact that we've seen such a rally in a long Treasury isn't something that's going to help them. Nothing dramatic though--they're still pretty much middle of the pack.

Benz: OK, PIMCO Total Return?

Bush: PIMCO Total Return's having a little bit of a rougher year. That is a fund that has had a long dollar exposure, so it actually had been short some currencies, I think particularly the yen. So that has probably hurt them. We don't have full attribution yet out for March. And they're also another shop that's been a little bit conservative on US duration, which at least relative to the [Barclays Aggregate Bond Index], would have hurt them.

Benz: You mentioned to me before we got started that the Barclays Aggregate has been a pretty tough foe for a lot of actively managed funds so far in 2016.

Bush: That's definitely been the case and that's actually been the case for several years now. Obviously, there's that cost advantage, so in a year like 2015 where returns were really muted or you were seeing losses from some of the more credit-sensitive funds, that if you look at the Vanguard Total Bond Market Index, it would have had an advantage, but it's also doing very well year to date.

Benz: OK, speaking of Vanguard, they came to market with a new fund, an actively managed bond fund with very low expenses. Let's talk about that one. It sounds like it's early days obviously, but...

Bush: It's early days and we don't rate it yet, but I would expect... They're definitely thinking about this as a core fund, so I think it's going to be fairly benchmark-conscious. That's true across their actively managed lineup, so I wouldn't expect this to be a fund that took on a ton of credit risk. They have a pretty tight cap on that. They'll probably have a little bit of flexibility around duration, but I think again, one of the big drawing points with these funds as with all Vanguard funds is going to be low expenses and the fact that we're in such a low rate environment. That's really going to be powerful going forward.

Benz: So this one is managed in-house by Vanguard?

Bush: It is, yes.

Benz: OK. Sarah, thank you so much for being here to share your insights.

Bush: Thanks very much, Christine. I'm glad to be here.

Benz: Thanks for watching, I'm Christine Benz for