Safe and Sorry — Even Bond Funds Can Disappoint

Kurt Brouwer April 10th, 2008

Many bond funds really struggled in the tough environment this year. Shefali Anand writes on what happened. You may also find a quote or two from a familiar name in this piece [emphasis included below]:

Safe and Sorry: Even Bond Funds Can Disappoint (Wall Street Journal, April 8, 2008, Shefali Anand)

…Bonds are supposed to be pillars of stability during times of tumult in the market. And indeed, the broad Lehman Brothers U.S. Aggregate bond index — which tracks taxable bonds, including Treasury notes, corporates and some mortgage securities — is up about 2.3% since the start of this year through April 4.

Yet a fifth of all investment-grade U.S. taxable bond funds tracked by Morningstar Inc. are in the red for that same period. A few bond funds that placed big bets on mortgage securities have posted shockingly big drops. The Regions Morgan Keegan Select Intermediate Bond fund is down 44% since the start of the year and 72% over the past year. State Street Global Advisors Yield Plus and Schwab YieldPlus have fallen 18% and 23%, respectively, since the start of the year.

And even the relatively successful funds that invest in inflation-protected Treasury securities — which are up as much as 6% so far this year — face new risks. If interest rates rise, the price of Treasury bonds will tumble — likely quite sharply in the short-term.

…To be sure, this is an unusual time for bond markets, and in some cases, it might serve investors well to hold for the long-term. If a fund has been hurt lately, investors shouldn’t necessarily dump it headlong. Try reading the manager’s recent commentary to figure out what is hurting the fund. Kurt Brouwer, a fee-only planner at Brouwer & Janachowski Inc. in Tiburon, Calif., suggests that investors might ask themselves if, based on the fund managers’ track record and holdings in the fund, they would buy the fund today. If not, it might be time to get out.

…Bond mutual funds didn’t used to be so complicated. In the past, investment-grade funds mostly invested in plain-vanilla bonds issued by the government and blue-chip companies, as well as mortgage-backed securities issued by federal agencies like Fannie Mae and Freddie Mac.

In the past several years, funds have been adding more-complex investments to their portfolios in a search for higher yields. These include mortgage securities issued by private financial institutions like Countrywide Financial Corp. and Citigroup Inc. Some of these mortgage securities were based on subprime loans — and that’s where much of the trouble has come from.

Over the past year, a soaring default rate for subprime borrowers has spooked the entire credit market and produced a massive selloff of mortgage securities. Many of the bond funds that have taken nasty tumbles in the past year were dragged down by this selloff.

Among the casualties: Metropolitan West Strategic Income fund, down 8% this quarter and 12% for one year; UBS Absolute Return Bond, down 8.5% year to date and nearly 15% over the past year; and Principal Investors’ Ultra Short Bond fund, down nearly 7% this quarter and nearly 10% over the past year.

Spokeswomen for UBS Global Asset Management and Principal Financial Group attributed their funds’ recent poor performance to turmoil in the fixed-income market. “Our overall fund-family performance is strong,” says a spokeswoman from Principal.

“It’s a difficult time for investors,” Mr. Brouwer, the financial adviser, says. One of the funds he uses for his clients, Western Asset Core Plus Bond, is down 0.7% year-to-date. Mr. Brouwer is still comfortable with the managers’ long-term track record and is sticking with the fund. He notes that a bulk of the fund’s mortgage investments are in securities issued by government agencies Fannie Mae or Freddie Mac, which are typically considered to be safer.

…Don’t expect bond funds to dump all their mortgage securities. Some fund managers are now buying additional mortgage securities, figuring there are some real bargains after the sell-off. They think that when the markets settle down, people will better differentiate between good and bad-quality mortgage-securities, and their investments will do well.

“These levels in the investment-grade market right now are just unbelievable opportunities,” says Robert Calhoun, manager of the Evergreen Core Bond fund. He says his team has “double, triple, quadruple checked the fundamentals” of their mortgage investments before buying some triple-A rated commercial- and residential-mortgage-backed securities. The fund is down 5.5% year to date.

For more on the outlook for bonds and the economy, see Bill Gross — Stop Falling Home Prices Now and Bob Rodriguez — Are We Crossing The Rubicon?.

The subprime lending mess has had a surprising impact on tax-exempt bonds too. For more, see Tax-Free Muni Bond Yields Now Above Taxable Treasury Yields.

 

Did you enjoy this article?

Trackback URI | Comments RSS

Leave a Reply