Bill Gross dethroned is half the story in bond funds

Bill Gross
Andrew Harrer | Bloomberg | Getty Images

Long lie the bond king, Bill Gross of Pimco, dethroned this past week as manager of the world's largest mutual fund. Gross's Total Return Fund finally lost the fund industry asset crown to Vanguard's Total Stock Market Index Fund. 

It's a nice data point, but in and of itself, it doesn't tell you much. The truth is, the asset flip-flop between the Pimco and Vanguard fund was a data point in the making for months—a fund fait accompli. The Pimco Total Return Fund had six consecutive months of outflows leading up to "regime change" in mutual funds, so Gross's slip offers investors little insight into how to make sense of the shifting investment landscape. 

Here are a few important themes that underlie this week's watershed event in the mutual fund industry.

Don't shoot the messenger

Bill Gross is as synonymous with bond funds as Jack Bogle is with fund fees and Steven Cohen is now with fund misdeeds—and Gross did notably get the interest-rate call wrong in a way he had not for decades before—but the asset outflows from Pimco Total Return are really just another way of stating the obvious in fixed-income: Investors ran scared from interest rates once the taper talk began, and even with the taper talk put off, they are still running, and investors don't want any exposure to duration in bonds.

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"Bond fund managers all face the higher interest-rate movement," said Jeff Tjornehoj, director of research at Lipper. "First we worried [the Fed taper] would happen in the fall, and that didn't happen, and now investors are starting to worry the taper arrives in 2014 and all the bond fund managers get crushed. I don't think that will happen. Even with the chaos this year, the taxable bond market continues to see investor inflows," he said.

Those inflows aren't impressive but are worth noting: The overall situation for bond funds may be better described as treading water. Bond funds have inflows of $48 billion this year, according to the most recent Lipper data. That's the lowest total since 2007, when bond funds took in $33 billion in assets. This year's organic growth rate in bond funds—a meager 1.4 percent—is the slowest growth rate for bond funds since 2000. 

"It's notable because it says a lot about investor appetite for core bond investing. Whether it's the right thing, people do seem to be turning away from core funds," said Eric Jacobson, head of fixed-income fund research at Morningstar. 

"Whether it's the right thing" is the key phrase in Jacobson's analysis.

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2013 bond mutual fund winners

Name YTD Flows ($mils) YTD Return Flows Rank (prelim)
Oppenheimer Senior
Floating Rate
9,697 4.99 1
Income Fund
6,904 4.45 2
Eaton Vance
5,577 3.43 3
Lord Abbett
Short Duration
Income Fund
4,662 1.2 4
Lord Abbett
Floating Rate
4,457 4.91 5
Fidelity Strategeic
Advisers Core
Income Fund
4,166 -0.81 6
Fidelity Advisor
Floating Rate
High Income
4,012 2.81 7
RidgeWordth Seix
Floating Rate
High Income
3,833 3.97 8
Templeton Global
Bond Fund
3,590 1.12 9
Eaton Vance
Advantage Fund
3,474 4.44 10

Less duration doesn't equal less risk

"Nobody wants duration anymore," Jacobson said. But investors do want bond funds, judging from the list of bond mutual funds that have taken in billions of dollars this year, especially floating rate—otherwise known as bank loan—funds, which are not as sensitive to changes in interest rates. There are also the unconstrained bond funds, often marketed as "strategic income" funds.

"It's almost become conventional wisdom that duration is bad and interest-rate sensitivity is bad," Jacobson said. "It's all about trying to keep duration short and keep income up in other ways. Everybody wants the silver bullet of the same return without taking more risk," he added.

And that's the point that shouldn't be lost on investors, fund researchers said: Escaping interest rate and duration risk means taking on entirely new kinds of risk within your bond funds. "It's hard to tell whether this is the right tactical move. There's a risk in investors making big changes to portfolios without taking into account adding highly correlated asset classes," Jacobson said. Bank loan funds and high-yield funds got destroyed in 2008 right alongside equity markets. In fact, Jacobson said, "One thing that would have saved you in 2008 was real interest rate duration, and nobody wants that today. That takes a big piece of insurance out of the portfolio," he said.

Investors are using unconstrained bond funds as core bond funds, but Jacobson said we've yet to see these funds go through a rough period. Lower duration doesn't equal lower risk, and investors don't have enough information on how these funds will hold up.

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2013 bond mutual fund losers

Name YTD Flows ($mils) YTD Return Flows Rank (prelim)
Franklin US
Gov't Securities
Fidelity GNMA
Yield Fund
PIMCO Investment
Grade Corporate
Bond Fund
American Funds
Bond Fund
of America
Return Fund
Core Bond
Securities Fund
Total Return

The Pimco fund that is getting money

Pimco has long been known as a "total return house" but the big winner at Pimco in recent years has been the Pimco Income Fund. In fact, while Total Return has been bleeding assets, Pimco Income was running at a billion dollars or more of inflows per month from January to May, and even though it had one month of significant outflows in June at the height of bond market panic, in October it was right back at the $1 billion mark for inflows, according to Lipper data. It now has more than $27 billion in assets—$12.5 billion in 2012 and close to $7 billion this year. 

Ranked by Morningstar as the No. 1 multi-sector bond fund in 2010 and No. 2 in 2012, investors have been chasing performance into this fund, but multi-sector is something of a misnomer in terms of the fund's recent run. The Pimco Income Fund is 41 percent in the mortgage market, according to Pimco data, and 16 percent specifically in securitized non-agency residential mortgages, according to Morningstar. Residential mortgages have continued to be priced cheaply relative to face value and still have been undertracked as an asset class because so many firms got out of the business. Non-agency residential mortgages were destroyed in the crisis, and the recovery values are warranted and are creating a huge amount of income as managers like Pimco sit on them. 

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The fund has been able to pay out a generous income stream because it is multi-sector and can be much more aggressive than a typical core bond fund, but Jacobson said that in some ways it is even more risky an approach than the unconstrained, or strategic income, funds.

"Non-agency mortgages with a few exceptions have been on fire," Jacobson said. "It's hard to imagine it can match the level of success it has had," Jacobson said. "To have that [residential real estate] sector undervalued for so long ... Opportunities like that in non-agency are a once-in-a-career opportunity, and it becomes more challenging because that non-agency market is shrinking. People should think twice before using this as a core fund," he said.

In other words, after the real estate crash, there was a real estate rave party, but that party has to slow down. 

"The party isn't over, but it's slowing because interest rates have started to rise," said John Harline, executive vice president of Vertical Capital Markets Group, which manages the closed-end Vertical Capital Income Fund. "If a potential home buyer was trying to get a loan approved at 3.75 percent and found it difficult, it's going to be much harder at 4.75 percent. Home prices, though, are still at 2004 levels, which is well below their peak in 2006." Unlike the open-end Pimco Income Fund, Vertical's closed-end fund buys whole mortgage notes and underwrites each note, serving as the direct creditor to performing debt acquired at discounts and creating a highly collateralized portfolio. 

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"Vertical Capital Income can continue the party, though, regardless of what happens," Harline said. "Nothing good has to happen for the fund to work. If homeowners just continue to pay their mortgages, the fund will be profitable and that will add to NAV. If the economy improves and housing prices continue to inflate, that will lead to more refinancing and sales of homes, which will allow us to take advantage of the discounts quicker."

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Bond funds as a tax-planning tool

Last in, first out might be an investing trend that applies to the selling in the Pimco Total Return Fund and bond funds in general. "I think because Total Return got so much attention from investors, it's natural to think the more recent investors might have felt misgivings about getting into bonds when they did and were the more likely ones to pull out," Lipper's Tjornehoj said.

Since the hot money is always chasing performance, investors were chasing the end of a 30-year bull market in bonds, and at the first sign of perceived crisis, the money raced out, Jacobson said. And that's understandable. "Even though the party is not completely over, these are the last several minutes of it," he said, then, referencing the end of quantitative easing:  "We've been waiting for this shoe to fall for how long?"

For investors with heady gains in equities needing a year-end tax-planning partner to match gains with losses and offset a tax bill, bond fund dogs could be an option—in fact, investors may already be using them in just this way.

By Eric Rosenbaum,