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Creating A Better Bond Fund Mix


BusinessWeek Investor: Mutual Funds

Creating a Better Bond-Fund Mix

Online tools help you find the right combo

Bond funds should be a natural choice for income-oriented investors. But so many funds have disappointed over the years, with their steep sales fees, high expenses, and ho-hum returns, that many people opt for U.S. Treasury notes or investment-grade municipal bonds.

In so doing, however, investors are missing opportunities. How else but in a mutual fund could all but the wealthiest people invest in a pool of adjustable-rate mortgages, a slice of a syndicated bank loan, or a New Zealand government bond? Indeed, if you build an income-oriented portfolio using low-cost funds that exploit these less familiar corners of the bond market, you can achieve a significantly higher yield with only a modest pickup in interest-rate and credit risk.

How much? BUSINESS WEEK constructed a diversified bond-fund portfolio, and its results are gratifying: Had you gone into it a year ago, you could have picked up about 1.7 percentage points in yield over a portfolio of short-term Treasuries. That may not sound like much, but in the bond realm, it's a virtual home run.

The portfolio we built has an average credit rating of about A- to BBB+, the lower end of the investment grade. Sure, the portfolio, like any fixed-income investment, could suffer if rates move up. But the damage might not be too bad. Even though long-term rates jumped more than one percentage point over the last year, this portfolio lost only 1.6% of its value. The principal on a pure Treasury portfolio would have dropped 2%. We went through a similar exercise with tax-free bond funds and built a portfolio with a 4.84% yield over the past 12 months. That's a little better than 1 percentage point over a portfolio of short-term munis. But alas, the portfolio took a bigger hit to its value than the bonds.

To assemble this sort of portfolio takes some thought and planning, and the tools to sort through thousands of funds efficiently. For example, visit the Interactive Mutual Fund Scoreboard at Business Week Online (go to www.businessweek.com/investor/, then click on Mutual Funds). Once there, you'll be able to sort funds by category and check total returns for a variety of periods, the trailing 12-month yield, expenses, sales charges, and BUSINESS WEEK mutual-fund ratings, which are based on five-year risk-adjusted total returns.

That's enough for the first cut. But you'll want to go deeper, getting a look at the credit quality of a fund's bond holdings and its sensitivity to changes in interest rates. The BW scoreboard also has links to Morningstar.com's "QuickTake" pages, which contain that information.CORE POSITION. You also need to know what you're trying to build--a portfolio that tries to squeeze out the most yield for the least risk. A high-yield bond fund is going to be a core position, because of its generous payout. But you'll need to offset the fund's credit risk with a like position in a high-grade fund. For true diversification, you'll also want to add smaller allocations in areas such as international bonds, mortgage-backed securities, and assorted short-term debt instruments.

For our taxable portfolio, we started with a 25% allocation to Fidelity High-Income Fund. The fund sports a BW rating of A when compared with all taxable funds, and an A when measured against its high-yield peers. Over the 12 months, the fund has earned a 14.38% total return and a 10.22% yield. That's not a guarantee of future returns, but its history shows it's usually a leader in high-yield. The average credit quality of the bonds in the portfolio is B (BB is the highest rating among high-yield bonds), so you are taking on credit risk. But Fidelity's high-yield research staff is among the largest and best in the fund business.ROCK-BOTTOM. To offset the high-yield credit risk, we allocated 25% to Vanguard GNMA. Ginnie Maes--the main ingredient of this fund--are government-backed mortgage securities. Their credit quality is nearly as good as Treasuries, but they pay a higher yield. True, they're interest-rate sensitive: Over the last 12 months, the fund's principal lost value. But the yield was high--6.76%. Vanguard's rock-bottom expenses are another plus. Indeed, another Vanguard fund, Vanguard Total Bond Market Index, would also make a good choice for this slot.

Then we put 15% in an international bond fund. Such funds can be scary if they buy emerging-markets bonds or take foreign currency bets. But Payden & Rygel Global Fixed-Income does neither. It's big on high quality--German government bonds are major holdings--mainly hedges against adverse moves in the dollar. The fund also adds diversification, as moves in overseas bond markets don't always correlate with America's. Over the last year, Payden & Rygel's yield was 7.78%. The fund rates BUSINESS WEEK's A ratings, both in comparison to all taxable funds and to those in its category.

We filled the rest of the portfolio with "ultrashort" funds. This is one area where interest-rate risk is minimal, but so are the yields. That's why the funds we choose are those that demonstrated an ability to uncover a little extra yield. They are Strong Advantage Fund, to which we give a 15% allocation; Asset Management Adjustable Rate Securities, 10%; and Eaton Vance Prime Rate Reserves, 10%.

Strong Advantage invests in instruments that are too long in maturity for a money-market fund and too short for a short-term fund. The fund keeps its average maturity below one year and seeks out undervalued securities. One minus: The average credit quality is just A. We also took on credit risk with Eaton Vance Prime Rate Reserves, one of several prime-rate funds (box). These funds invest in syndicated bank loans whose interest rates are reset every three or six months, so rising rates don't hurt the principal. There is credit risk, but you get paid to take it--the yield over the last 12 months was a tidy 6.56%.PLUMPER YIELDS. For the final piece, we offset the credit risk in the Strong and Eaton Vance funds with Asset Management Adjustable Rate Securities. Unlike other funds of this type, Asset Management buys private as well as government-backed securities. Its average credit quality is AAA, and it sports a 5.41% yield for the last 12 months.

For a tax-free portfolio, the job is a little easier because the muni-fund market is not as diverse as the taxable. But the building plan is the same. Buy two funds that invest in intermediate maturities, two in shorter maturities, and one that takes on high risks.

Whether you choose taxable or muni portfolios, keep an eye on your allocations to make sure they don't get too far out of line. If you get capital gains distributions, plow them back into the fund--that helps maintain the portfolio's capital base. And you need to keep up with the funds' performance to make sure you're getting the best risk-adjusted returns in the sector. But with some effort, you should be rewarded with a plumper yield.By Jeffrey M. LadermanReturn to top


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