(PUB) Morningstar FundInvestor

20

Digging Into the Big Bond Backup Income Strategist | Eric Jacobson

indexes actually contracted by a few basis points during May, suggesting that investors weren’t making a statement that corporate bonds were any less desir- able than Treasuries. On the other hand, it does help highlight the fact that the high-quality corporate-bond market is plenty sensitive to interest-rate moves. In part, that’s because the corporate-bond market skews to longer-maturity issuance than the Treasury market currently does. But it also highlights that corporate yields have come in so close to Treasuries’ in recent years that their fortunes have for now become inter- twined. In fact, that “yield spread” is now tighter than at any time since before the financial crisis. Back in the Day The Treasury and corporate indexes have years of history during which their returns—and directions— were closely linked. Things cracked a little in the early part of the 2000 s but really broke apart in 2007 when financial-crisis worries began sending the two sectors in opposite directions. They’ve converged again for stretches since the crisis but have other- wise shown a lot of independence, as in 2012 , when their return gap was a healthy 783 basis points. Returns of the two indexes have again converged over the past several months. The indexes’ returns have been highly correlated for the year to date through May 31 and were separated by only 33 basis points, as compared with big 2012 gap. That’s a reminder that despite—or, in fact, because of—the fat overall returns for corporate bonds since the financial crisis began to soften in early 2009 , high-grade corporate bonds have become a lot more of what they once were, modest providers of excess yield, but also with considerable interest-rate expo- sure. It is therefore worth taking a good look at your portfolio and eyeballing just how much of your credit exposure comes in the form of high-quality corporate bonds. A large number isn’t necessarily bad, but, at least for now, it doesn’t appear to offer much diver- sification from Treasuries, either. œ Contact Eric Jacobson at eric.jacobson@morningstar.com

At this point you’ve probably heard that May 2013 was a bad month for bonds. With the exception of the shortest-dated debt, Treasury bond yields in- creased across the maturity spectrum by similar amounts; the 10 -year note gapped out roughly 50 basis points during the month. With a few exceptions, longer-maturity Treasuries naturally lost more than their shorter cousins. The losses incurred were some of the sharpest suffered over a single month in a long time. The Barclays U.S. Treasury Index tumbled 1 . 70% . If you’ve been listening to the pundits, meanwhile, you also probably know that PIMCO Total Return PTTRX suffered losses last month—it fell 2 . 15% . Interestingly, the fund’s outsized pain didn’t trace back to its increased stake of conventional Treas- uries from the month before, but mostly to a long- standing long-maturity allocation to Treasury Inflation- Protected Securities (and a bit to the fund’s 8% emerging-markets allocation). At the same time, the Barclays Aggregate U.S. Bond Index fell 1 . 80% , while the average intermediate-term bond fund got the better of both with a 1 . 60% loss. More Than Meets the Eye In fact, there’s more to the May story than just Trea- suries. Some of the most credit-sensitive—and therefore more yield-rich—sectors were cushioned from that market’s influence, and Barclays’ high-yield index dropped only 0 . 58% for the month. Lost in the headlines, however, was that, in addition to TIPS , higher-quality corporate bonds also endured par- ticularly hefty losses: Barclays’ U.S. corporate-bond benchmark actually fell even more than its Treasury counterpart with a 2 . 30% loss.

There’s some interesting nuance to those numbers. The yield spread between the corporate and Treasury