Time for a look under hood of lagging bond funds

The Baltimore Sun

There's a difference between reacting to short-term market wiggles and overreacting to them.

So while experts routinely tell fund investors to ignore day-to-day deviations, what happens over a month or two can be telling, particularly in bond funds.

And based on what has been going on in the mortgage and credit markets for weeks now, this is a time for many bond fund investors to react and recheck their position.

That's not a call to sell bond funds, but rather to examine performance more closely, because the wild conditions that the market has lived through since the end of June have created the perfect crucible for stress-testing a bond fund's portfolio and your tolerance for what the fund holds.

You can sum up the current situation this way: It's a great time to be a tortoise, the bond markets were so favorable that bond fund managers had an easy time putting up decent results. The hares - the funds that stretch for extra yield - were rewarded for taking high risks.

While that appeared to be changing in the early part of 2007, there's no doubt it changed by June 30. That's when the market effectively re-priced risk, and a four-year trend of tightening credit spreads effectively reversed itself over the course of a month. Treasury yields are down sharply, and when yields fall, bond prices rise.

That's created an interesting situation. Bond funds set their daily share price by "marking to market," meaning they price each bond as if they were going to sell it. When yields come down, prices go up. That helps to explain why the Lehman US Aggregate Bond Index is up 5.6 percent through early August.

Just under one-fifth of that increase came in July alone.

Not all types of fixed-income securities have benefited from the move. Mortgage-backed securities, some junk bonds and other areas have been hurting.

Those types of investments, typically, were the kinds of things that those hares were buying to get the jump on the slow-and-steady crew. Thus, the tortoises among general bond funds - the ones that stuck to their knitting without trying to goose yields - have been able to catch up and, in most cases, take a lead.

"With bond funds, this is a time to take your temperature - in terms of whether you can handle losses - and then the temperature of your fund to see if it's been running fast and is now out of breath," says Morningstar bond fund analyst Paul Herbert.

And that's why in this unusual case, it's worth looking at short-term performance and drawing conclusions from it.

"Most people buy bond funds with certain expectations, and if your bond fund is not performing along the lines of its peers and its benchmarks over the last four to six weeks, then there's a very good chance it is investing in some securities that might make you nervous," says Mary Ellen Stanek, portfolio manager for the Baird Aggregate Bond fund (BAGSX).

"A fund manager has to do something specific to have performance that deviates substantially from the stated benchmark. If the tracking error in the short run has been substantial, it tells you the fund is probably doing something you didn't expect."

Even if performance has suffered since June, automatically selling would be an overreaction. Investor nerves right now have more to do with the volatility in the bond market, rather than with actual locked-in losses. Instead, recent performance may be a call to look more closely at the fund and how it pursues its strategy.

Bond funds are inherently murkier than their stock cousins; the average investor can't look at a bond portfolio, pick out a few tickers and get a sense of what the fund is doing. Instead, they could find a bunch of unrecognizable names, representing bonds with any number of embedded features that won't show up on a laundry list of holdings.

The performance numbers, however, won't lie. And if they paint a picture of a fund that has overreached for yield and underperformed as a result, react appropriately.

That means calling the fund for a current breakdown on holdings and strategy. There's nothing wrong with holding mortgage-backed securities or junk and more, so long as it's what you expected the fund to do. There's something very wrong with being kicked around because your fund owns securities you ordinarily avoid.

Says Jeff Tjornehoj, senior research analyst at Lipper Inc.: "This is one of those rare cases where short-term fluctuations have opened up a curtain and showed investors the ugly side of some funds, the ones that are supposed to be safe and provide steady income. ... If you are concerned about the performance of your bond fund, you owe it to yourself to take a look."


Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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