A significant amount of bond portfolios in the Wealth Management and 401-k space hold as a strategic long term holding a “core” and potentially add specialty managers as satellite positions.  In many cases there is a large percentage of the portfolio in one position such as a “total return fund” that bolsters the core. Given the significance of the core in terms of assets, we will examine a couple funds that hold a lot of assets and that hold a position in many investors portfolios.

The Barclay’s US Aggregate Index is the main index for most core funds benchmark. One of the problems is that it has not evolved with the growth and dynamics of the overall bond market. It holds a 38% position in Government Debt as well as a 28% holding in Mortgage Backed Debt. 20% is in corporate debt and cash represents 13%. This breakdown explains the modest 2.18% yield. There is a chance that this index does well in a “risk-off” environment or in the case of continued disinflation but that is a lot of sector risk for a core portion of a portfolio.

We are not predicting an imminent demise of the Treasury and Mortgage Backed markets but if an investor has a total return fund as its core with the Barclay’s US Aggregate Index as the benchmark, they possess a lot of interest rate risk over the next few years.

PIMCO has a fund for most asset classes and its flagship Total Return Fund has been a strong option for investors who do not want to invest passively in a core ETF such as AGG. As a core holding, the PIMCO Total Return (PTTRX) has done a very good job at absolute and risk adjusted performance as well as gathering assets. It has over $236 Billion in just its original Total Return fund.

You are paying a 50 basis point fee for Mr. Gross and company’s view on major debt classes and right now they hold Treasuries and Mortgage Backed Debt at about 82%. This may pay off and they have had years of sizable out performance so this is not out of the question as they can make money on capital appreciation in the future but the current SEC yield is only 1.45%.

While they can use derivatives to help bolster returns and to enhance liquidity and expand into additional segments such as emerging market debt and credit, these tools did not help returns over the last year as they were essentially flat.  Remember, this fund is in a significant amount of 401-k programs and exposes the investor to institutional and sector risk. Long term, it makes sense from a risk perspective to expand the choices and to carve up the core to include other managers with alternative views on the markets.

The West Coast has another bond powerhouse TCW that runs a $4.6 Billon dollar Total Return Fund (TGLMX). Tad Rivelle is at the helm after Jeff Gundlach moved on to form his own firm. This potentially core holding given its Total Return label has a major focus on mortgage backed securities as you pay .44% to own a core fund that as its mandate will own at least 50% in mortgage backed securities. This includes prime, sub prime and alt-A debt.  Current yield is 3.14%  with a 4.22 duration and the fund regularly beats its benchmark, the Barclay’s Aggregate Index, so it does its job. We would however consider it primarily a mortgage backed fund and should potentially be used as an alpha producing sector fund.

Both PIMCO and TCW have flexibility in their respective Total Return Funds although as a core holding, we would suggest paring back on these as their mandate may not be flexible enough given their benchmark going forward. The forces that helped Government Debt and Mortgage Backed bonds may not disappear overnight but they will not be around forever. A long term strategic core position needs additional managers in sector specialties or in a fund that has much less constraint.

PIMCO feeling constrained by the core mandate created the Unconstrained Fund (PFIUX) to expand your opportunity set. This $26 Billion fund is also managed by Mr. Gross and places a lot of investor’s assets behind the macro bond outlook by this seasoned and successful veteran. This fund also has a lot of money in US Government related and Mortgage Backed bonds totaling about 51% and an additional 13% in non-US Debt. They have flexibility as the duration can range from negative 3 to positive 8 and is around 3.54 currently. With that risk you garner an SEC yield of .91% with a fee of .9%

This fund with an opportunity set that includes most global bond classes and nimble flexibility with regard to interest rates has returned on average 2.46% over the last three years. That is not an acceptable return stream in our view. We do like the nimbleness with regard to credit markets, duration management and the global opportunity set but this unconstrained fund is simply not worth the investment. We will have an exclusive piece on additional funds in this space that do warrant consideration.

We sense that investors are at a tough juncture with regard to their fixed income allocation since the traditional core holds a low yield and the potential for a real impairment of capital if rates rise substantially. For firms that are not allowed to move 100% into equities or alternatives, bonds remain an asset allocation fact of life. Given that reality, does it make sense for a firm to slice off a portion of the core to an unconstrained fund? We feel that it warrants further review given the massive amount of money piled into Treasuries and Mortgage Backed Securities under total return products.

While we respect both Pimco and TCW, there is simply too much institutional, personality and sector concentration for a continued long-term strategic placement in these total return funds.  We understand the complexities of the bond market and the sense of security with these big names but now is a great time to truly review your core fixed income to explore additional opportunities.

Sincerely,

Tom Koehler, CIO

“Bond markets represent a complex asset class and while we covered a small amount, there is a lot more information needed prior to making an investment decision. Let us know if we can provide more information to help in that process.”

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