Morningstar Advisor - June/July 2010 - 32

Spotlight

particular are susceptible to extension risk, or the risk that investors will refinance their mortgages at a slower pace than anticipated, sticking bondholders with lower interest payments for longer. PIMCO’s Bill Gross falls into this uncertainty camp. He’s recently cut back exposure to areas that have rallied in his flagship fund, PIMCO Total Return Bond PTTRX, particularly investment-grade corporate bonds and agency mortgages. But instead of turning to Treasuries, he’s taking interest-rate risk in areas his team thinks are less likely to feel the same upward pressure on yields, including in countries such as Germany, Canada, and Brazil. As of March 31, his fund staked as much as 18% of assets in developed-markets debt outside the United States. Many other high-quality managers don’t have the same flexibility.
The Fuss

loans can offer even more direct protection against rising rates. Their interest payments periodically adjust upward along with a short-term reference rate such as the London Interbank Offered Rate. And although they’re also typically issued by companies with a lot of debt on their balance sheets, they enjoy a senior claim on company assets that takes precedence over bondholders. Dan Fuss and his comanagers at Loomis Sayles Bond LSBRX are prominent examples of those managers using credit risk to fight interest-rate risk. In addition to bulking up their high-yield bond stake in recent months, they’re also turning to areas that offer some potential for capital appreciation, including bonds issued in so-called commodity currencies—the Australian, Canadian, and New Zealand dollars—and convertible bonds. Unlike straight bonds, convertible bond prices are often driven by movements in the prices of their underlying common stocks. Both of these approaches come with their own sets of risks. The former leaves investors exposed to a sudden rise in high-quality bond yields, while the latter could struggle if the economy takes a turn for the worse, or if mounting concerns about developed sovereign risk spark a flight to safety. It’s unclear which approach will have the upper hand in the year ahead. No matter which path you take—The Gross, The Fuss, or some combination of the two—the better you understand how a bond fund is preparing for today’s challenges, the less likely you are to get caught up in fighting the previous decade’s battles. K
Miriam Sjoblom is an associate director of mutual fund analysis with Morningstar.

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Other managers are more confident that the economy is on the mend, and they view rising yields as the primary risk facing bond investors today. As a result, they’re opting to take credit risk over interest-rate risk. This isn’t as simple as “chasing yield.” Improving corporate fundamentals, supported by a shrinking default rate and an uptick in rating agency upgrades versus downgrades, justify tighter yield spreads at this stage in the credit cycle. That’s a key difference between today and the pre-crisis era of 2006-07, when underwriting standards were deteriorating, fundamentals got worse, and credit spreads were minuscule. Lower-quality bond prices could also be resistant to rising Treasury yields. With an additional yield advantage of 400 to 600 basis points over Treasuries, these securities throw off more income to offset an identical rise in rates. In addition, junk-bond yields often don’t move in sympathy with Treasuries, because rising Treasury yields are often the side effect of a stronger economy, a scenario that favors junk-bond yields. Leveraged

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Morningstar Advisor - June/July 2010

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