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A Lackluster Year for Bond Funds

Richard Widows

Last year was generally steady but unspectacular for open-end bond funds. While all but 98 of 4,491 bond funds tracked by TheStreet.com Ratings finished in positive territory, the average fund tallied a mediocre 4.80% total return, including dividends. (TheStreet.com Ratings treats each share class of a mutual fund as a separate fund.)

Despite an economic expansion that has been getting long in the tooth and a stubbornly inverted yield curve, which is often a harbinger of an economic downturn, funds that invest in riskier bonds outperformed.

When investors are concerned about the economic outlook, they tend to put their money in more conservative investments, pushing prices of these securities higher. At such times, people also pull money out of high-risk bonds, pushing prices down. But that didn't happen last year.

Of the 20 top-performing bond funds in the accompanying table, 11 are high-yield funds, which invest in the bonds of companies with below-investment grade ratings. Funds that invest in equally risky emerging-market securities also were well-represented. They benefited from strong economic growth in key parts of the world, as well as the appreciation of many currencies vis-à-vis the U.S. dollar. Two global income bond funds, which are usually considered riskier than mainstream bond funds, also achieved top 20 status for the year.

Stock and bond investors alike might interpret the strong performance of high-yield and emerging-market bond funds last year as a sign that the securities markets are overly optimistic or have a speculative mentality.

High-yield and internationally focused bond funds tend to take their owners on more hilly rides than most other categories of bond funds. This had a negative effect on their ratings, because our model takes both total return and volatility into consideration.

All but two of the top 20 bond funds achieved grades in the C range, which equates to a hold recommendation. The (DPHYX Quote)Delaware Pooled Trust High-Yield Bond fund edged into the buy area with a grade of B-minus and (ACYRX Quote)American Century High Yield lacked sufficient data for a rating grade. (Only funds with a track record of at least three years are given grades, as denoted in the first column.)

Whereas each of the 20 leading bond funds achieved a positive return on principal, every one of the laggards suffered a decline by that measure (investment return without assumed reinvestment of dividends). Because their total investment returns were negative, that meant the negative principal returns more than offset any dividends they paid out. Also, only seven of the laggard funds have made dividend payments to investors over each of the last 12 months, vs. 14 of the leaders.

Not one of the laggards rewarded its owners with a dividend yield of 4%, which was the average for the bond funds tracked by TheStreet.com Ratings. And of the laggard group, only the (BTTRX Quote)American Century Target Maturity 2025 fund was able to capture a C grade for a hold recommendation. All the others ended unrated or at the bottom of the ratings scale, with scores in the E range, which equate with "sell" recommendations.

A dozen of the underperformers implicitly promise to immunize their owners from erosion of wealth resulting from inflation. They are the ones with phrases such as "Inflation Protected" and "Inflation Managed" in their names. They obviously didn't deliver last year.