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Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

Despite some recent performance troubles, bond funds have had very good returns so far in 2010. Here to provide some color on what's been going on in the bond world is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thanks so much for being here.

Eric Jacobson: Glad to be here. Thanks, Christine.

Benz: So, Eric, let's talk about bond funds as a group; they've performed really well, but what have been some of the better-performing categories within this asset class.

Jacobson: Pretty much anything that had a generous amount of income or yield performed really well. And the most obvious reason for that, I think, is that the Fed has kept short-term interest rates very low; they have done a lot of things to keep interest rates relatively low across the board. A lot of factors like that have really triggered a tendency among investors to look for higher-yielding assets to provide income. And so anything with a lot of income, high yield for example, has done really, really well over the course of 2010.

Benz: And in general, the longer you've been, the better off you've been, until very recently.

Jacobson: By and large that's correct, also, because the yield curve, if you will, the spectrum of maturities from short- to long-term bonds has been what we say is relatively steep.

So, in other words, if you go from left to right, from the shorter to the longer maturities, the yields have been higher at the long end than at the short end. So, that steepness makes long maturity bonds more attractive simply from a yield perspective. Although people have to remember, of course, that there is more interest rates sensitivity, there is more volatility.

Benz: Right. So, in general risk has been rewarded so far in 2010. In terms of categories that haven't performed as well, is that pretty much the flip-side--so anything shorter term or taking less risk performed relatively less well?

Jacobson: Absolutely. Again keeping in mind that we're speaking about the year in general, that's absolutely correct. As you said, the shorter maturity sectors have not performed well. The muni market in fact leaned a little bit on what we are talking about in terms of things that have happened in the last month, but also in general, the yields on municipals have been relatively low versus history in terms of the raw numbers, and that has made it difficult, I think, for them as well--people not as interested in them. So municipals, if you look at it over the course of the year, not as good, and certainly the very short term stuff--ultrashort, short term bond--have not performed especially well as one would expect.

Benz: Right. You're not earning much on your cash. You shouldn't expect to earn a lot more on short-term bonds.

Jacobson: That's right.

Benz: Okay. So, Eric, we've seen this stampede of assets going into bond funds. Let's talk about where they've been going. And I understand there's been a little bit of a pullback recently, but year-to-date very robust flows into bonds overall.

Jacobson: That's right. If you look at the three categories that have seen the largest inflows over the course of 2010, they have all been fixed-income categories.

Benz: So, across the whole mutual fund universe, they are all going into bonds?

Jacobson: Exactly. The intermediate-term bond category, which is the home to what we think of as the core universe of bond funds, including PIMCO Total Return, the big daddy, if you will, enormous flows, both last year and this year, but the largest of any mutual fund category at all for 2010 at about $74 billion, something like that.

Benz: Okay. You said short term bonds also ...

Jacobson: Short term bonds and in fact world bonds, which has been sort of a big story this year in terms of people flocking overseas, looking for more income as well.

Benz: So, that's a little counterintuitive, because arguably the eurozone has more financial problems right now than here in the U.S. What's driving that quest into world bonds?

Jacobson: Well, part of it is that we're talking about different time periods. So, there have been times at which those bonds have looked particularly cheap, flows have been strong. The other issue is that, a lot of world bond funds haven't necessarily been focused only on Europe, certainly.

There have been managers who have been very excited about what they see available in Asia, and a number of world bond funds hold a reasonably significant stake in emerging-markets debt. And the interesting thing there, of course, is that some of these emerging-market economies that we still call "emerging markets," they are by many measures, but their credit quality is improving, their underlying fundamentals, the sovereign balance sheets have looked good. So, those kinds of markets have found their way into the world bond category. So, I am not saying that it's necessarily all smart money that's done this, but there have been some sound reasons that managers have chosen the markets they have and that people have chosen to buy world bond funds as well.

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Benz: So, I want to follow up on the comment about emerging markets because that's another category that has seen very robust flows, and certainly on a percentage basis, big inflows into that group as well.

Jacobson: That's right. And I think some of that is sort of logically tied to these discussions that managers have been having with their advisors and with the public in the last couple of years about which economies stand to benefit from sort of this new world order that we're in, and in addition to the fact that they offer a lot of income relative to what you can get in the U.S. So, we've seen this very dramatic shift, relatively speaking, into emerging markets, and the latest numbers I looked at showed flows that were something like 75% of the assets that the category started with on top in terms of what flowed into this category over the course of 2010.

Benz: I want to shift gears a little bit, Eric, and talk about specifically what's been happening recently, because it's kind of have been a reversal of some of the things we've been talking about, where long-term bonds have gotten hit very hard, and another category that might surprise people is that the TIPS group has really come in for some pain here, too. Can you discuss what's going on there and why that's happening?

Jacobson: Sure. Well, the TIPS story is a tricky one, but it's one that is really important for people to pay attention to because what we have here is a little microcosm of what happens every now and then when you face a situation in which actual inflation doesn't actually, pardon the repetitiveness, but inflation doesn't actually rise in real time, and so the adjustment to principal does not necessarily happen in a large block overnight, so it doesn't drive up the principal value of the TIPS bond if you will.

On the other hand, what happens in the rest of the market is people start to get spooked by inflation. So, Treasuries in particular start to lose value. As their yields widen, as we say, or as their yields rise, effectively what you're seeing there is a widening of what we call the "real yield" above and beyond the inflation compensation.

Now, that may be confusing to people because they are saying, well, those yields are rising because of inflation fears. But the fact of the matter is that actual inflation adjustment that you see in the TIPS bond isn't moving. So, as the yields on regular, what we call nominal, plain-vanilla conventional bonds, start to go up, they start to look more and more attractive to investors in all areas, whether you are talking about pre- or post-inflation, because they just start to offer more and more income, and the only way for TIPS to remain competitive is for their yields to go up as well, and their prices to go down. And one of the reasons that the effect is so dramatic is the nature of the TIPS market. It is not a perfectly homogenous market that is evenly distributed the way that we sort of think of the regular Treasury market. It tends to be very focused in longer-term maturities and by and large the universe of TIPS that's out there has a fairly long duration, if you will, a very, high sensitivity to longer-term movements.

Benz: Right. So, that's I guess something to keep in mind. If you are concerned about rising rates, TIPS are going to be just as vulnerable as some of these other categories.

Jacobson: That's right. Eventually, you'll probably make up for it in terms of your inflation adjustment if that's in fact what happens and so forth, but on a day-to-day basis, they can be very, very volatile. Again, if we start to rotate toward that, we have rates go up and then a real true inflation scare starts to come where people start plowing money into the sector, it might even out. But by and large, TIPS are going to be a fairly volatile asset class for that reason.

Benz: Okay. So, I want to double back on PIMCO Total Return. You mentioned the big-daddy of the bond categories. What's going on there? A little performance hiccup here toward the end of the year anyway.

Jacobson: So, Bill Gross and PIMCO have been looking for different areas of the bond market to focus themselves over the last year or so, because they haven't wanted to take on as much interest rate risk and they've been looking for places that will be sort of less susceptible to some of the issues in the U.S. and Europe, in particular, that we've all been worried about. And November was just a troubling month for them. It wasn't a disaster, but they definitely had a little bit of a hiccup as you said, so they had an allocation to high yield that didn't work out well because the high-yield sector was off more than a percentage point, and that allocation hurt them.

Within their investment-grade corporate allocation, which has been larger than it used be for a number of years, they've been really focused on what they look at as very, very strong financial firms that have just rock-solid ability to deliver on their promises to return investor capital. But they got volatile again in the month of November.

They also had some exposure to Brazilian local interest rates, which is a little bit unusual. Historically, they haven't taken on as much local interest rate exposure, and some emerging-markets currency, and both of those were off for the year, as was the Build America Bonds market, which they had some exposure, too, as well.

Benz: Okay. So, Eric, finally I wanted to touch on the interest rate concerns that a lot of investors have. What do you say to investors who are looking at their fixed-income allocation right now, thinking, is this a sucker's bet given what might be set to happen with interest rates over the next couple of years? What do you say to people in that position right now?

Jacobson: Well, the first thing I would say is, it's very difficult to tell right now if we are on the precipice of a big turnaround, or if we might lumber along again for another several months. A lot of what's happened in the last month has been very news oriented--very much a reaction to the tax bill, and also what's been going on in Europe, these countercurrents bouncing back and forth. I think that there is a general sense among a lot of the managers that we pay attention to and respect that things are a little better than they were a month or two ago in terms of the outlook, but not necessarily some sort of runaway inflation, or runaway growth story.

That said, it always make sense for people to go back and look at their portfolio, certainly at the end of the year, and say, okay, what do I own and how much sensitivity to the markets do I have? So, in other words, it may or may not be a case that you have too much bonds overall. But let's just say that the allocation that you have to bonds makes sense given your overall picture--what you need the money for, how much volatility you can take, etc. It may deserve another look in terms of what you wanted to be allocated to within the bond market, though. So, if you have a lot of rate sensitivity or you have a lot of very high-quality, long maturity portfolios in there, well, that's something to reconsider. Maybe you want to think about evening that out a little bit, taking things a little shorter.

You've got to remember though that unless you are willing to take on more credit risk perhaps or this kind of emerging-markets risk we were talking about, some of those things, you've got to be willing to ratchet back a little bit on the income, because the shorter-term stuff just isn't earning that much money. And at least as of right now, the market is not expecting the Fed to start hiking anytime soon.

So, as long as the Fed stays in this mode of keeping short rates very, very low, and as long as they keep this so-called QE2, or quantitative easing 2, program going, where they're buying about $75 billion worth of longer-term bonds every month, that's going to keep a depressive effect on rates.

And one thing that we haven't been talking about a lot in the last couple of weeks, but is going on right before our eyes is all the stuff that's happening in Europe. If Europe continues to sort of – I don't really want to say this in a horrible way – but sort devolve into the kind of bickering that they're having in the EU and the question of whether or not they're going to support each other in terms of their debt, whether or not the euro is going to survive--the longer that goes on, the more skittish investors globally are going to be, the more they may retreat to the dollar.

The more they do that, the more that that happens, regardless of what policy we have going on here, that's likely to keep a lid on rates as well, and keep the dollar at least stronger than it might otherwise be.

So, I don't think that that's necessarily a risk to someone who wants to take a little risk off the table in their bond portfolio. But it's something to remember as a countervailing force to all of this fear of rising rates, as by the way is the fact that we still have a tremendous amount of unemployment.

So, I'm not telling people, oh, don't worry, rates aren't going to rise, because nobody can really tell you that. If new data comes out next week, we might see something change; it could flip around. But as of right now, the fear on Main Street about rising rates is a little bit higher than what the fundamentals seem to suggest and what a lot of the managers we respect seem to feel.

Benz: Okay. Eric, that's great context, and we so appreciate the summery of the past year. Thanks for being here.

Jacobson: My pleasure. Thanks for having me.

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

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On Morningstar.com: 2010 Fund Category Performance
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