THERE ARE two reasons that a bond fund tops its peers: It has lower expenses or it does something goofy.
In an environment in which investors are trying to balance safety with top performance, it has never been more important to know how your prospective top bond fund achieves its results.
"Investors who start out looking at a bond fund's yield are doing it backwards," says Eric Jacobson, associate director of fund analysis at Morningstar Inc. "When you buy a top stock fund, you have a good idea of what they did to get on top, and you understand the volatility that comes with a top ranking. With a bond fund, unless it's low cost, you have no idea what kind of games could be going on in the portfolio."
The fund industry is filled with examples of bond funds gone amok, done in by the high-risk investing proclivities of management.
Three Heartland junk muni-bond funds were taken over by the Securities & Exchange Commission early this year, after suffering huge losses last year, when the abnormal proportion of super-risky garbage in them turned out to be nearly worthless. The funds had gotten five-star ratings from Morningstar as recently as nine months before they cratered.
In the mid-1990s, any number of funds were hit by the credit crunch that forced Orange County, Calif., into bankruptcy and by their tendency to invest in "inverse floaters," a Wall Street concoction that is structured to pay higher yields when market interest rates fall, making it something of an "anti-bond."
Then there is the odd case of the Pauze US Government Limited Duration fund, which was up roughly 12.4 percent in June, despite supposedly owning the most benign of securities. (It gained 8 percent June 12, more in one day than most funds will earn all year.) Those numbers in a "safe" fund will make even the staunchest stock jockey take notice, and maybe consider bonds more closely.
The Pauze folks aren't saying what happened, though they have said it was a one-time event.
So here are a few theories floating around the industry: Pauze might have been dabbling in zero-coupon bonds, making an interest-rate play, though that would hardly be described as a nonrecurring event. The jump might also have been caused by holdings left over from when Pauze US Government was Pauze Total Return Bond. Or it could have been caused by a redemption so big that the fund had to redeem securities over a day or two to pay up. The customer would have been credited with the closing price on the day of the trade, but if the securities went up between the order and their sale, it would have created a bonus for everyone left in the fund.
Regardless of what happened with Pauze, every expert agrees that no government bond fund with expenses nearly double the industry average (currently about 0.85 percent) and a 4,200 percent turnover rate (100 percent for a government bond fund would be closer to typical) can sustain its performance.
That applies not only to strange situations such as that of Pauze, but to more everyday bond funds, too.
Ask anyone who follows the bond-fund business these days and you'll hear that those inverse floaters and other esoteric goodies are creeping back into portfolios, especially the ones that are overcoming high expenses to generate good numbers.
"The first question you want to ask is 'Why do I want bonds in the first place,'" says Gerald Perritt, editor of The Mutual Fund Letter. "If you want something risk-averse and steady, you can't pursue the top-performing bond funds based on absolute returns, because you'd wind up in junk, and you'd only buy the top funds in a category if it got to the top by keeping expenses low."
When it comes to bond funds to add safety to a portfolio, the determining selection factors should be time horizon, costs and potential tax benefits.
Some industry watchers think the safety-minded investor might consider taking a backward approach when it comes to bond funds, as in "the lower the yield, the better the fund," at least in terms of credit quality and risk-aversion.
Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at firstname.lastname@example.org or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.