Morningstar Advisor - June/July 2010 - 35

Bond Bonanza: More assets went into fixed-income funds in 2009 than in the previous five years combined.

Munis’ Year: Municipal-bond funds gathered an unprecedented $72 billion in assets in 2009 as credit worries grew. $80B 70 60 50 40 30 20 10 0 –10 –20

Indexes Gain: An increasing share of taxablebond-fund assets went into index funds in 2009, just as headwinds were forming. $1,600B 1,400 1,200 1,000 800 600 400 200
Active Passive (ex. Leveraged funds)

$400B 350 300 250 200 150 100 50 0 –50 00 01 02 03 04 05 06 07 08 09

00 01 02 03 04 05 06 07 08 09

Aggregate Bond Index, may face challenges because they own outsized portions of government-backed bonds. When the credit crisis struck, investors fled to the safety of Treasury bonds, boosting valuations in the sector, while increased issuance raised Treasuries’ weighting in fixed-income indexes. Although panicked buying of Treasuries abated in 2009, the government’s influence on bond indexes has continued via agency mortgage securities. Prices of those securities were supported by the Fed’s buying program. At the end of the first quarter of 2010, Treasuries, agency mortgages, and other government-related bonds made up 78% of the Barclays Capital Aggregate Bond Index. Treasuries alone accounted for 29% of the index’s assets, compared with just 17% for the typical intermediate-term bond fund. Meanwhile, the index’s weighting to corporate bonds amounted to just 19% compared with 32% for the intermediate bond category average. Securities backed by the U.S. government are still considered some of the safest investments in the world, but that doesn’t mean they are risk-free. Price risk is a concern. Neither Treasury bonds nor agency mortgage-backed securities are attractively priced. Current yields on the Barclays Capital U.S. Treasury and U.S. Mortgage-Backed Securities indexes hover near historic lows. Interest-rate risk is also a

worry. Higher-quality bonds (like Treasuries and government-backed mortgages) are more vulnerable to rises in interest rates than lower-rated bonds. Although rate hikes don’t seem imminent, interest rates will eventually rise, and when they do, Treasury and agency mortgage bond prices will come under pressure.
Short Memories?

unscathed, and it is hoped that they’ll continue to meet shareholders’ expectations for a relatively smooth ride.
Shareholders’ Staying Power May Be Tested

Ultrashort-bond funds gathered $13.8 billion in 2009, making it the 10th-most-popular fund category for the year. They’ve pulled in an additional $3.4 billion in the first quarter of 2010. These inflows have more than made up for the $10.7 billion in outflows the category experienced in 2007 and 2008. This reversal of fortune is remarkable when you consider the spectacular blowups the category witnessed in 2008, including Schwab Yield Plus SWYSX, and the now-defunct SSgA YieldPlus and Evergreen Ultra Short Opportunities. Perhaps investors have short memories. More likely, their desire for yield in today’s low-interestrate environment has trumped other concerns. There is some comfort in the fact that the bulk of the new inflows have gone to some of the more judicious funds in the category, such as PIMCO Short-Term PSHAX (which accounted for half of the category’s inflows in 2009), Franklin Adjustable U.S. Government Securities FISAX, and DFA One-Year Fixed-Income DFIHX. Such funds came through 2008 relatively

With risks lurking, bond-fund returns could come under pressure. That could shake out investors who don’t have realistic expectations about bond-fund volatility. In 1999, the last time the fixed-income market experienced a downturn, bond funds saw noteworthy outflows that began later that year and continued throughout most of 2000. From September 1999 through December 2000, $57.8 billion exited bond funds. But they quickly made up that lost ground in 2001 and 2002 when investors once again sought shelter from the crumbling stock market. A downturn in the bond market will likely cause some shareholders to dump their bond funds, but the level of outflows will depend on the factors that have driven investors to the asset class in the first place. For example, if rising rates allow CDs or money market funds to offer attractive yields, bond funds could face serious competition. On the other hand, if fixed-income funds manage to limit volatility relative to other asset classes, they stand a good chance of holding on to their shareholders. K
Sonya Morris, CFA, is an associate director of fund analysis at Morningstar.

MorningstarAdvisor.com 35

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Morningstar Advisor - June/July 2010

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