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The Increasing Risks of Bond Index Funds

The Western Asset fund ranks as one of the stars of the recent downturn. While most bonds lost money in May, Western Asset gained 1.2% for the month. The fund holds securities that are backed by pools of mortgages, which often yield more than Treasuries and tend to be resilient in downturns. "The mortgage market is one of the few fixed-income sectors where you can get some shelter from higher rates," says portfolio manager Steve Fulton.

While most mortgage securities cannot default because they are backed by government agencies, Western Asset has about a quarter of its assets in non-agency mortgages. Those did not qualify for government backing because the loans were too large or homeowners had weak credit records. While the non-agency mortgages can default, they compensate with richer yields. In May, non-agency securities performed particularly well. With the economy improving, investors figured that the risk of default was lower and bid up prices of shakier mortgages.
[Read: <a target="blank" data-add-tracking="true" href="http://www.thestreet.com/story/12024311/1/5-sin-stocks-ready-for-dividend-boosts.html"><em>5 Sin Stocks Ready for Dividend Boosts</em></a>]

Scout Core Plus Bond has the flexibility to range widely, holding emerging markets bonds one year and shifting to Treasuries the next. The fund typically has a duration that ranges from three years to seven years. "The idea of holding static bond positions is not going to work in the kind changing market environment that we face," says portfolio manager Mark Egan.

Earlier this year, Egan worried that interest rates had sunk to unsustainably low levels and were bound to rise. For protection, the fund took a defensive stance, moving away from low-quality bonds and shortening maturities. The caution enabled the fund to outdo peers in May, losing 0.8%. Remaining wary, Egan has a duration of 3.75 years, which should help Scout continue to outperform if rates rise.

Another flexible fund is Frost Total Return Bond. Portfolio manager Jeffery Elswick is free to buy a wide range of securities of different credit qualities. The approach has produced winning results, returning 1.2% this year, while the Barclays Aggregate lost 2.8%. Elswick has scored gains with unloved commercial mortgage-backed securities, which are backed by portfolios of mortgages on office buildings and other properties. He has favored mortgages that were issued in 2005 and 2006, the height of the real estate frenzy. "Those have traded at large discounts because there is a perception that the loans were not sound," he says.

Following an unorthodox strategy, Ave Maria Bond stayed in the black in May. Unable to find bonds with attractive yields, portfolio manager Richard Platte, Jr. had more than 10% of assets in cash. In addition, he held some dividend-paying stocks, which can rise when most bonds fall. Much of the rest of his portfolio was in bonds with relatively short maturities. "We have been very concerned about rising interest rates for some time," he says.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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