11
Morningstar FundInvestor
July 2
013
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.
TIPS: No Shelter for Rising Real Rates
May served as a reminder that funds designed to pro-
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.
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
TIPS Take It on the Chin in a
Harsh Month
Red Flags
|
Flynn Murphy
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.
