NEW YORK (TheStreet) -- Some pessimists worry that investors have been acting like lemmings, blindly racing into bonds. In the past 18 months, more than $600 billion has flowed into bond funds, an unprecedented movement, according to the Investment Company Institute. If interest rates rise in the next year, as many economists expect, bond prices could fall-- and novice shareholders will be shocked.
But some new bond funds are likely to prove resilient, even if the market goes over a cliff. The portfolio managers sell short and use other techniques to protect investors in downturns. The funds do not have long track records, but the early results are encouraging. When many competitors collapsed in 2008, the short sellers provided some protection.
Iron Strategic Income
, which has returned 11.0% annually during the past three years, outdoing 99% of high-yield bond funds. Most the fundâ¿¿s strong showing can be attributed to the performance during downturn. In 2008, Iron Strategic lost 8.0%, outdoing its average peer by 16 percentage points.
The Iron portfolio managers aim to hold a diversified portfolio of high-yield bonds. To do that, the fund invests in a mixture that can include mutual funds and ETFs, as well as individual securities. When the managers become wary about risks, they can hold cash or sell bonds short. In a short sale, an investor borrows a security and sells it, hoping that the price will drop. If that happens, the investor can go repurchase the security at a low price, pocketing a profit.
As risks mounted in 2008, the fund shifted so that only 20% of the assets were exposed to the high-yield market. Since then the managers have turned more bullish, and the exposure has increased to 90%. Because the fund rarely has 100% exposure, it could trail typical high-yield funds during roaring bull markets. But by controlling losses in downturns, the fund aims to outperform over the long term, says portfolio manager Aaron Izenstark. â¿¿We want to capture most of the upside while limiting the downside.â¿
The fund currently has most of its assets in high-yield bond mutual funds, including
Fidelity Advisor High Income
Goldman Sachs High Yield Institutional
. Whenever he can, Izenstark buys the institutional class of fund shares, which come with small expense ratios and must be purchased in large quantities. â¿¿The expense ratios are so low on institutional shares that it is cheaper to use the mutual funds than it is to trade ETFs or individual securities,â¿ he says.
Another notable short seller is
MainStay High Yield Opportunities
. Not only did the fund outperform in the downturn of 2008, but it also surged during the rally of 2009, returning 54% and outdoing 81% of competitors. To achieve such results, Mainstay uses a variety of tools. Besides selling short, the portfolio managers raise and lower the quality of holdings as market conditions change. â¿¿We are trying to outperform the market on the way down and the way up,â¿ says portfolio manager Michael Kimble.
With clouds appearing on the horizon in 2007, the fund began gravitating to senior bonds, which come with less risk. As conditions improved, the fund took on more risk, buying bonds from
, which sold for 20 cents on the dollar. When the outlook for the car market improved, the GM bonds surged.
At the moment, Kimble is preparing for the day when interest rates rise. He is emphasizing bonds with maturities of five years. During periods of rising rates, such intermediate bonds tend to be more resilient than long bonds. In addition, the fund is shorting Treasuries. If rates rise, Treasuries would sink, and the short position should produce profits. That could enable MainStay to outdo conventional high-yield funds.
Investors seeking to diversify a bond portfolio, can consider
Driehaus Active Income
, which holds a mix of long and short positions. Operating like a hedge fund, Driehaus aims to deliver positive returns every year while maintaining little correlation with stocks and bonds. So far the fund has achieved its goals. During the past three years, Driehaus has returned 8.2% annually, outdoing 73% of its multisector bond competitors.
The fund is particularly interesting these days because it can stay in the black during periods when interest rates are rising. â¿¿When interest rates go up, we are not hurt the same way that a plain-vanilla bond fund is,â¿ says portfolio manager K.C. Nelson.
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