Resilient Bond Funds for a Difficult Market

During the past five years, intermediate-term bond funds have delivered solid results, returning 5.6% annually, according to Morningstar. Will the performance be as healthy in the next five years?

Probably not, says Jeremy DeGroot, chief investment officer of Litman/Gregory, which publishes No-Load Fund Analyst, a respected newsletter. DeGroot figures that the Barclays Aggregate Bond index will return 1% to 2% annually.

He bases the forecast on the assumption that the Federal Reserve's efforts to flood the economy with cash will succeed. The economy will improve slowly, and the demand for loans will increase. That will help to boost interest rates. In a likely scenario, rates on 10-year Treasuries will rise from the current 2.5% back up to 4.0%, a level that last occurred in October 2008.

When rates rise, bond prices tend to fall. But results will stay in the black because bond total returns come from two sources: nterest income and rises in bond prices. In coming years, higher interest income will help to compensate for declines in bond prices, and total annual returns should approach 2%. If interest rates climb to 6%, a figure that is near the historical average, then bond investors would receive 1% total returns.

DeGroot concedes that his forecast could prove off the mark. But under any likely scenario, bond returns will be modest. For example, if rates drop to 1.5%, funds would produce capital gains, but total returns would only be 3%.

In this difficult environment, plain-vanilla bond funds will deliver meager results, DeGroot says. The typical intermediate-term bond fund roughly tracks the Barclays Capital Aggregate bond index, a high-quality benchmark. Treasuries and other AAA-rated securities account for three quarters of the assets in the index. When rates rise, prices of such high-quality issues can sink sharply.

For better results, consider lower-quality issues, says DeGroot. The low-quality issues often prove resilient in difficult markets, especially during periods when rates are rising because the economy is growing. At such times, investors often bid up prices of low-quality issues since there is less fear of defaults.

With the outlook cloudy, should you avoid investment-grade bonds altogether? No, says DeGroot. While investors should underweight high-quality bonds, they should hold at least some investment-grade issues. "Investment-grade bonds can help to diversify a portfolio, and that is important at a time when the economy faces headwinds," he says.

For today's difficult environment, the best choices are broad-ranging funds that have the ability to own a mix of securities, including investment-grade as well as high-yield and foreign bonds. DeGroot favors the Loomis Sayles Bond ( LSBRX), which has the freedom to buy securities of all credit qualities from around the world.

The fund often holds big stakes in high-yield bonds, which are rated below investment grade. The Loomis Sayles portfolio managers seek to buy undervalued assets, and most often they have succeeded. During the past 10 years, the fund has returned 10% annually, outdoing the Barclays Aggregate by 3.6 percentage points.

Loomis Sayles currently has 23% of assets in high-yield credits. The fund also has big positions in securities from commodity-producing countries, including Canada, New Zealand, and Australia. Helped by strong sales to the emerging markets, the commodity countries do not face big budget deficits. That should help the commodity currencies to appreciate against the dollar and boost bond returns.

Another fund that can thrive under a variety of market conditions is Osterweis Strategic Income ( OSTIX), which has returned 8.3% annually during the past five years, outdoing the Barclays Aggregate by 1.7 percentage point. Portfolio manager Carl Kaufman has outpaced the benchmark by keeping most of his assets in high-yield bonds. The fund currently yields 6.0%. To limit risk, Kaufman focuses on bonds with short maturities of five years or less. Those rarely default or swing wildly during market shifts.

DeGroot also owns PIMCO Total Return ( PTTDX), the giant portfolio run by bond star Bill Gross. Now that the fund has $255 billion in assets, some analysts worry that Gross will no longer be able to trade nimbly and outdo rivals. But DeGroot sees no signs that the fund is slowing down.

Gross achieved a stellar track record by making a series of dead-on market calls. Some years, he focused on Treasuries, while other times he dipped into emerging markets bonds. "No matter what happens in the markets, PIMCO is likely to be positioned to benefit," says DeGroot.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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