A Lackluster Year for Bond Funds

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.)

Top 20 Open-End Bond Funds High-yield, emerging-market funds scored big gains in 2006 but get low marks for volatility
Fund Name, Ticker and TSC Ratings Grade	Objective	2006 Total Return (%)	2006 Principal Return (%)	12-Month Dividend Yield (%)	No. of Dividends Latest 12 Months
J Hancock High Yield A - (JHHBX) - C+	Corporate - High Yield	20.25	10.37	7.67	12
American Century High Yield Bd R - (ACYRX) - U	Corporate - High Yield	19.37	12.42	5.75	12
Metropolitan West Alpha Trak 500 - (MWATX) - C+	General Bd - Short & Interm	17.47	9.97	6.55	4
PIMCO Intl StkPlus Tr Strat A - (PIPAX) - C+	General Mortgage	17.35	1.12	14.78	4
Fidelity Adv Hi Income Advantage A - (FAHDX) - C+	Corporate - High Yield	15.57	8.12	6.10	12
GMO Emerging Country Debt III - (GMCDX) - C+	Emerging Market Income	14.81	5.72	8.24	2
WM High Yield Fund A - (CPHYX) - C+	Corporate - High Yield	14.47	6.36	6.82	12
Westcore Flexible Income - (WTLTX) - C	General Bd - Investment Grade	14.26	6.99	6.33	12
DWS Emerg Mkts Fx Inc Fd A - (SZEAX) - C+	Emerging Market Income	14.00	7.53	5.39	4
Delaware Delchester Fund A - (DETWX) - C+	Corporate - High Yield	13.69	5.25	7.15	12
Thrivent Diversified Inc Plus A - (AAHYX) - C+	Corporate - High Yield	13.64	6.83	5.60	12
Templeton Global Bond A - (TPINX) - C	Global Income	13.51	7.26	5.30	12
Federated International High Inc A - (IHIAX) - C+	Corporate - Investment Grade	13.34	6.65	5.59	12
IXIS Loomis Sayles High Income A - (NEFHX) - C	Corporate - High Yield	13.26	5.86	6.29	12
Legg Mason High Yield Prim - (LMHYX) - C+	Corporate - High Yield	13.06	5.38	6.79	12
Pioneer Global High Yield A - (PGHYX) - C+	Global Income	12.71	4.53	7.06	12
SunAmerica High Yield A - (SHNAX) - C+	Corporate - High Yield	12.66	5.08	6.52	12
JPMorgan High Yield Bond A - (OHYAX) - C+	Corporate - High Yield	12.58	4.40	7.10	12
Delaware Pooled Tr-High Yield Bond - (DPHYX) - B-	Corporate - High Yield	12.43	3.89	8.18	1
SEI Intl Tr-Emerging Mkts Debt Tr - (SITEX) - C+	Emerging Market Income	12.43	6.13	5.50	4
Source: TSC Ratings. Excludes leveraged and "inverse" funds. U=Unrated

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.

Bottom 20 Open-End Bond Funds Inflation protected bond funds fail to deliver
Fund Name, Ticker and TSC Ratings Grade	Objective	Total Return (%)	Principal Return (%)	12-Month Dividend Yield (%)	No. of Dividends Past 12 Months
Delaware Inflation Protected Bond B - (DIPBX) - U	US Government - Short & Interm	-0.27	-3.36	3.17	8
American Century Infl Prot Bd A - (APOAX) - U	General Bd - Investment Grade	-0.28	-3.72	3.40	12
MassMutual Inflation Protected Bd A - (MPSAX) - E-	General Bd - Investment Grade	-0.28	-3.56	3.23	1
TA IDEX PIMCO Real Return TIPS B - (IRRBX) - E-	Corporate - Investment Grade	-0.30	-3.46	3.25	9
Fidelity Adv 529 Inflatn-Prot Bd A - (N/A) - E-	General Bd - Investment Grade	-0.33	-0.33	0.00	0
JPMorgan Real Return A - (RRNAX) - U	General Bd - Investment Grade	-0.40	-3.52	3.10	7
Principal Inv Infl Prot AdvSel - (PBSAX) - U	General Bd - Investment Grade	-0.41	-3.69	3.39	8
Harbor Real Return Fund Retire - (HRRRX) - U	US Treasury	-0.42	-3.79	3.49	4
PL Inflation Managed Fund A - (PPAIX) - E-	General Bd - Investment Grade	-0.48	-2.93	2.38	5
JPMorgan 529 Inf Pro-Fee Struct A - (N/A) - E-	US Government - Long	-0.55	-0.55	0.00	0
Fidelity Adv Inflation-Protect Bd B - (FBIPX) - E-	General Bd - Short & Interm	-0.72	-1.99	1.30	12
Tamarack Tax-Free Income C - (TTRCX) - U	Municipal - National	-0.72	-3.41	2.82	12
MFS Inflation Adjusted Bond B - (MIABX) - E-	US Government - Short & Interm	-0.79	-3.54	2.85	12
RVS Inflation Protected Sec B - (APSBX) - U	General Bd - Investment Grade	-0.82	-3.74	3.04	11
BBH Real Return Fund A - (BBIAX) - E-	General Bd - Investment Grade	-0.86	-4.21	3.38	7
PIMCO Real Return Fd B - (PRRBX) - E-	General Bd - Investment Grade	-0.91	-3.21	2.38	12
First American Inflation Protect C - (FCIPX) - U	Global Income	-0.94	-4.47	3.72	12
American Century Tgt Mat.-2025 Inv - (BTTRX) - C	US Treasury	-1.21	-1.21	0.00	0
DWS Inflation Protected Plus A - (TIPAX) - U	US Government - Long	-2.17	-3.53	1.40	12
FFTW Worldwide Core Portfolio - (FFWHX) - E	Global Income	-2.28	-4.46	2.27	11
Source: TSC Ratings. Excludes leveraged and "inverse" funds. U=Unrated