This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Bond Funds With an Edge

NEW YORK ( TheStreet) -- Wary of falling stock prices, investors have been fleeing to bond funds.

Among the popular choices are two solid index funds, Fidelity Spartan U.S. Bond Index (FBIDX) and Vanguard Total Bond Market Index (VBTLX).

Both track the Barclays Capital U.S. Aggregate bond index, and they have outperformed most competing intermediate-term funds during the past decade.

But Robert Arnott, chairman of Research Affiliates, is not impressed with such popular index funds. Like most market benchmarks, the Barclays index is capitalization-weighted, he says.

Under that system, bond issuers are weighted according to their total debt. So a struggling borrower with huge amounts of debt will have a bigger weighting than a competitor with little debt and a pristine balance sheet.

That is no way to run a bond fund, says Arnott. "A cap-weighted index rewards bad behavior," he says.

Arnott has a point. The Barclays index aims to represent the broad U.S. investment-grade market. Because it emphasizes the largest borrowers, the benchmark's heaviest weighting is connected to the biggest debtor of all: Uncle Sam.

About 70% of assets in the index are Treasuries and mortgage-related securities that have high ratings because of government backing. The recipe protected investors during the market turmoil of 2008. But now that Standard & Poor's has downgraded the U.S. credit rating, Treasuries could sink, and the Barclays index could take a hit.

>> Get your mutual fund news on the go with TheStreet's iPad app.

To give investors choices that avoid the problems of cap-weighting, Arnott is developing funds that follow fundamental indices. These give more weight to companies with greater assets and other indicators of performance. "The idea is to weight bonds in proportion to the borrower's capacity to service debt," he says.

Arnott's first offering is an exchange-traded fund, the PowerShares Fundamental High Yield Corporate Bond (PHB), which invests in bonds that are rated below investment grade.

The fund weights bond issuers according to a variety of factors, including total sales, profits and stock dividends. Under the fundamental system, companies that have more sales and profits would have heavier weightings than issuers with small sales and scant profits.

Arnott argues that his fundamental approach gives more emphasis to higher-quality companies. Over time, that should enable the fund to suffer from fewer defaults and outdo cap-weighted high-yield competitors.
1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
HYG $82.96 -0.65%
PHB $18.20 -0.33%
AAPL $95.18 1.64%
FB $117.43 -0.96%
GOOG $692.36 -0.84%


Chart of I:DJI
DOW 17,750.91 -140.25 -0.78%
S&P 500 2,063.37 -18.06 -0.87%
NASDAQ 4,763.2240 -54.37 -1.13%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs