September 8, 2013

Losers vs. Bigger Losers: Bond Lessons From the Summer Sell-Off

Morningstar looks at how some top-rated bond funds fared in May and June and what investors should expect going forward

News about possible Fed tapering led to a sell-off in the early summer months, even though no action actually was taken by monetary authorities.

To understand what caused the dramatic response and how it affected some popular bond funds, Morningstar recently shared the views of senior fund analyst Eric Jacobson, who outlined some important lessons for bond investors and advisors to keep in mind.

“Things get priced in early sometimes,” Jacobson said in a videotaped interview with Christine Benz, director of personal finance for the Chicago-based research firm. “So in this case, it's all about fear. Everybody is worried … and that just sent shock waves through the marketplace and triggered all that worry in a sell-off and brought yields up to a place where they hadn't been for quite a while.”

In the intermediate bond category, the analyst says, one of the best performers during the early summer was the Dodge & Cox Income Fund (DODIX), which lost about 2%. One of the worst, he adds, was the PIMCO Investment Grade Corporate Fund (PIGIX); it dropped by more than 6% during those two months.

Working against the PIMCO fund, Jacobson explains, is its use of a longer benchmark.

“It uses a credit index and doesn't have the mortgages that are in the Barclays U.S. Aggregate, and those mortgages tend to have shorter, lower durations,” he said. “So this fund even at neutral to its benchmark is fairly long in its maturity and its duration.”

In addition, there are sector issues. The PIMCO fund had part of its portfolio in lower-rated natural gas pipelines, along with an overweighting to metals and mining.

As for the PIMCO Total Return Fund (PTTRX), Jacobson says, one of its problems was that portfolio manager Bill Gross “came into the period a little bit long, and in particular, the fund also had a reasonable allocation to TIPS,” which “sold off quite badly during the interest-rate shock.”

In other words, even when a fund has a minor allocation in a certain holding, that holding can play a significant role in a fund’s overall performance.

Still, Jacobson believes that “very often Gross has been early and still right. I'm not saying that's automatically going to be the case here, but I still think he is one of the best managers in the business.”

Working in favor of the Dodge & Cox fund has been its short duration vs. that of other funds in the category. The fund’s managers have been “very concerned and cautious” about the interest-rate markets, according to the analyst, which has “been a huge help.”

In addition, the portfolio has had slightly more exposure to credit-sensitive bonds, which performed better than the worst-hit bonds, i.e., municipals and long-duration Treasuries, he adds.

Other Funds

The Janus Flexible Bond Fund (JAFIX) also has more of a short-duration flavor relative to its benchmark and some peers. Plus, Jacobson points out, it has a lot of mid-quality corporate bonds, which performed relatively well during the May-June period.

There’s also the MetWest Total Return Bond (MWTRX), another shorter-duration fund in the category that outperformed many of its peers. This fund, the analyst says, has held a lot of mortgages.

Mortgages “tended to hold up a little better during this shock, partly because of the way they're structured and the fact that they have shorter duration," Jacobson said. "The fund was just very, very light in Treasuries as well.”

As for the Scout Core Plus Bond Fund (SCPZX), which has Reams Asset Management as a subadvisor, “what they got right [is] they had a very short duration of only two years, and so that was a big factor in [why] they were able to really beat up everybody else, if you will, with a modest loss.”

Long-Term View

With investors turning from traditional bond funds to nontraditional ones, like high yields or bank loans, valuations in the most credit-sensitive sectors are starting to “get a little frothy,” Jacobson fears.

“It may take a while to develop,” he said, “but at some point, if investors continue to flee the most rate-sensitive parts of the market, they will get cheaper and the high-yield, more credit-sensitive stuff will get more expensive.

Though nontraditional bonds may have outperformed core funds in May and June, they “didn't completely protect investors from all losses,” he says.

Investors may “get some cushion from these nontraditional bond funds, given that a lot of them are relatively light in interest-rate sensitivity and a little heavier in other kinds of risks, sometimes credit risk,” Jacobson said, “but they're not a silver bullet and they're not a panacea, and they're not going automatically protect you.”

Rather than looking for escape routes from their current bond funds, the expert advises investors and advisors to “look again at what your asset allocation is, why it is the way it is, and try to be faithful to what your plan is.”

If it’s a long-term strategy, and the holdings are less risky than equities and that’s what the objective is, then there may not be a need for a course correction.

Some bond categories, Benz points out, can be more equity sensitive than others, making a whole portfolio more responsive to the equity market and economic shifts.

High yields, Jacobson says, are “particularly low in the capital structure, a lot closer to equity than to high-quality bonds, and you do wind up having those higher correlations in your portfolio, which you've got to be careful about.”

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Check out PIMCO’s Gross Dodges Total Return’s Strikeout With Baseball Metaphors on ThinkAdvisor.

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