(PUB) Morningstar FundInvestor

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Morningstar FundInvestor

July 2 013

TIPS Take It on the Chin in a Harsh Month Red Flags | Flynn Murphy

They supplement their TIPS stake with high-yield developed- and emerging-markets bonds. For an added boost, they also use derivatives and invest the cash backing those derivatives in short-term bonds. The funds’ 4 . 6% – 4 . 7% decline in May serves as a warning sign that even topnotch inflation-protection funds are exposed to interest-rate risk. Emerging Markets PIMCO Real Return’s struggles point to another theme from May: Emerging-markets bonds took Treasuries’ lead and sold off sharply. The average emerging- markets bond fund declined by 4 . 3% in May, making it one of the worst-performing bond sectors. Investors bought roughly $ 21 billion of shares in emerging-markets bond funds in the 12 months through April 2013 . The category offers relatively fat- ter yields than comparable developed-markets bond funds. But investors may not have been prepared for May’s lurch in emerging-markets bonds, as Morn- ingstar’s data suggest shareholders yanked more than $ 3 . 1 billion from category funds and exchange- traded funds in June. Neutral-rated Goldman Sachs Local Emerging Markets Debt GAMDX and Gold-rated PIMCO Emerging Local Bond PELBX were the two hardest- hit bond funds with at least $ 1 billion in assets in May, losing 6 . 8% and 6 . 9% , respectively. The two funds take very different approaches. The PIMCO fund takes a relatively conservative path, investing in the debt of countries with stronger fundamentals such as Brazil, Mexico, and South Africa. The Goldman Sachs fund charts a more aggressive course, investing in securities such as Chinese and Indian currencies and frontier-markets bonds. The funds’ May perform- ance shows that both conservative and aggressive emerging-markets bond strategies can wobble under the pressure of rising rates. For more on the bond market’s swings, see the Income Strategist article on page 20 . œ Contact Flynn Murphy at flynn.murphy@morningstar.com

May provided a glimpse at how bond funds, as cur- rently positioned, will respond to rising interest rates. In May, Treasuries sold off, causing the 10 -year Treasury yield to jump by half a percentage point to 2 . 16% from 1 . 66% . Long government bond funds, which predominantly hold Treasuries maturing in 20 – 30 years, behaved as expected by losing 6 . 8% on average during the month. But you might have been surprised by the damage done at some other funds. tect against inflation can still send shareholders reeling when real interest rates rise. Treasury Infla- tion-Protected Securities, which are linked to the Consumer Price Index, compensate investors when inflation rises. However, the worst-case scenario for TIPS —and the inflation-protection funds holding them—is a growing economy and rising interest rates coupled with declining inflation. That scenario arose in May, as the United States economy exceeded expectations while China’s ongoing slow- down muted inflation. The Barclays US TIPS Index fell by 4 . 4% in May. The typical inflation-protected bond fund fared slightly better than the benchmark but still gave shareholders a jolt. For example, Neutral-rated Fidelity Inflation- Protection Bond FINPX lost 4 . 3% in May. After it was hurt in 2007 by exposure to subprime mortgage- backed bonds, the Fidelity fund refocused to stay close to the index and focused on higher-quality do- mestic fare, avoiding inflation-protected bonds issued outside of the United States. Two funds that took it on the chin were Gold-rated PIMCO Real Return PRRDX and its near-clone Harbor Real Return HARRX . The funds have the same manager, Mihir Worah, and the same strategy. TIPS: No Shelter for Rising Real Rates May served as a reminder that funds designed to pro-

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.