The Year in Bond Funds by Morningstar Investment Research 
 

"Prediction is very difficult, especially about the future." –- Niels Bohr. 

Coming into 2014, prognosticators had the fixed-income markets all figured out. Many posited that it would be a rough year for U.S. Treasuries and other rate-sensitive bonds as the Fed unwound its bond-buying program. Meanwhile, riskier assets, including junk bonds and bank loans, seemed poised to outperform against the backdrop of manageable corporate-debt levels, decent economic growth, and strong investor appetite. Munis were a trouble spot amid bad news out of Detroit and Puerto Rico, while many thought of Russia as a relatively high-quality name in the emerging-markets arena. Finally, Bill Gross was still synonymous with PIMCO Total Return (PTTRX), which, despite some outflows the previous year, was sitting on net assets of close to $240 billion. 

It's fair to say that script played out differently. Below we recap several of the biggest stories in bond fund land from 2014. 

The PIMCO Saga and the Reshuffling of the Intermediate-Term Bond Category 

Bill Gross' departure from PIMCO and from the helm of the once-largest fund in the world was one of the biggest fixed-income stories of the year. While the fund's outflows continued at a hefty pace through November, there are encouraging signs that things are stabilizing at PIMCO. Significant investment staff departures have yet to materialize, while several key contributors who left the firm in recent years have returned. The current leadership team seems energized despite outflows. Perhaps more importantly, while PIMCO Total Return is lagging the Barclays U.S. Aggregate Bond Index since Gross left, it is doing a bit better than its intermediate-term bond peers, providing some comfort that redemptions aren't taking a significant toll on performance. Morningstar downgraded the fund's Analyst Rating to Bronze from Gold following Gross' exit to reflect the uncertainty associated with its transition to a multimanager-run fund in a post-Gross world. However, that Bronze rating also reflects the unparalleled depth of PIMCO's investment resources. 

Gross' departure had implications well-beyond PIMCO's headquarters in Newport Beach, California. Bond managers have scrambled to take their share of PIMCO's massive outflows. Within the intermediate-term bond Morningstar Category, the home to most core bond funds, Vanguard has been a biggest winner, with estimated net inflows to index juggernaut Vanguard Total Bond Market Index (VBMFX) of $19 billion for the year to date through November. Metropolitan West Total Return (MWTIX) has also seen substantial flows ($17 billion) as have Dodge & Cox Income (DODIX) ($11 billion), Fidelity ($8 billion across several funds), and DoubleLine Total Return (DBLTX) ($6 billion). 

An Unanticipated Bond Rally 

Turning to the markets, 2014 showed once again how hard it is for fixed-income managers to get interest-rate bets right, especially in the short term. Against the backdrop of geopolitical risk, a softer-than-expected global economic outlook, and pension fund rebalancing, long U.S. Treasuries enjoyed an unexpectedly strong rally. By Dec. 18, the 10-year U.S. Treasury yield stood at 2.20%, down from 3.04% at year-end 2013. The 30-year enjoyed an even more impressive run. Long Treasuries were the best-performing part of the market through mid-December, catching many core managers, who had positioned their funds for an increase in bond yields, flat-footed. However, some, including the team at Silver-rated Western Asset Core Plus Bond (WACPX), benefited from a decision to favor longer-maturity bonds. The rally was much more muted in shorter maturities, and the yield on the three-year Treasury actually increased over the course of the year, reflecting in part the expectation that the Fed will start to raise short-term rates, however gradually, sometime in 2015. 

The rally in long investment-grade bonds has helped propel the Aggregate Index to a 5.6% return for the year through Dec. 18. All sectors enjoyed solid gains, with midquality corporates a particularly strong performer. For the first time since 2011, active funds in the intermediate-term bond category have had a difficult time beating this bogy, with roughly three quarters of the universe lagging the broad benchmark year to date. 

Read More at: MorningStar