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The Hazards of Bond Index Funds

Government bonds could suffer a particularly steep fall because of the actions of the Federal Reserve, warns Howard Greene, portfolio manager of John Hancock Bond (JHNBX).

Under its quantitative easing programs, the Fed has been buying billions of dollars worth of Treasuries and government-backed mortgage securities each month. That has temporarily propped up prices of government issues.

"As long as the Fed keeps buying a lot of the new issues, the bond benchmark may be able to hold up," Greene says. "But after a while, the buying will stop, and the game will be over."

Investors are not being compensated for the risk of Treasuries, portfolio managers argue. The Treasuries in the Barclays benchmark yield a puny 0.90%. Overall the Vanguard fund yields 2.6%.

To get a higher yield and more protection from a decline in Treasuries, consider an actively managed fund with a big stake in corporates and a long track record for outdoing the benchmark. Top choices include Janus Flexible Bond (JANFX), John Hancock Bond, and MFS Bond (MFBFX).

Holding 89% of its assets in corporate bonds, MFS Bond yields 4.2%. During the past five years, the fund returned 8.4% annually, outdoing 95% of intermediate funds.

Portfolio manager Robert Persons has most of his assets in bonds that are rated triple-B, the lowest rung in the investment-grade market. Those issues yield around 3.5% and present little default risk. For some extra juice, he has 18% of assets in bonds that are rated double-B, the highest rating of the below-investment grade universe.

Persons aims to buy strong double-B-rated companies that are improving their credit qualities. He says that his favorite double-B-rated bonds deserve to be considered investment grade. "We want bonds that should soon be upgraded by the ratings agencies," he says.

Last year, 3% of the MFS holdings were upgraded to investment grade, says Persons. When a bond is upgraded, the price immediately rises as investors rush to buy the improved issue. Persons says that many index funds and institutional investors cannot buy bonds that are rated below-investment grade.

John Hancock Bond, which yields 4.4%, has 44% of its assets in corporate bonds and only 7% in Treasuries. During the past five years, the fund returned 8.3% annually. Portfolio manager Howard Greene attributes part of the strong showing to a stake in mortgage securities that are not backed by government agencies.
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