3 Bond Funds That Can Beat the Pack

NEW YORK ( TheStreet) -- Because of their low expenses, index funds often outdo 60% or more of their actively managed competitors. But in some recent years, Vanguard Total Bond Market Index ( VBTLX) has delivered unusually strong performance. In 2008, the fund surpassed 91% of intermediate-term bond competitors, and last year Vanguard topped 88%, according to Morningstar.

Do the results prove once and for all that active managers aren't worth the fees they charge? Hardly. Vanguard's strong showing is due to temporary shifts in the bond markets. Soon enough the pendulum is likely to swing the other direction, and active managers will easily outdo the benchmark.

Like many bond index funds, Vanguard Total Bond tracks a version of the Barclays Capital U.S. Aggregate bond index, the most popular fixed-income benchmark. Seeking to mimic the investment-grade bond markets, the Barclays index holds a mix of Treasuries, corporate bonds and mortgage-backed securities. The benchmark gives each sector roughly the same weight as it has in the markets.

In recent years, the biggest issuer by far has been Uncle Sam. Struggling to finance mounting expenditures, the government has sold a flood of bonds. Now Treasuries account for 35% of the Barclays benchmark, up from 21% in 2002. The big Treasury stake has helped to keep the index funds afloat in recent downturns. During difficult periods in 2008 and 2011, corporate bonds sank as investors worried about defaults. At the same time, Treasury bonds soared because they offered safety. Since many active managers have big stakes in corporate bonds, their funds trailed the Barclays index.

Now many analysts argue that Treasuries have become too expensive. If interest rates rise, Treasuries could fall sharply. That would pull down the Barclays index, enabling most actively managed funds to outdo the benchmark.

While Treasuries will fall eventually, the downturn could be several years away. The Federal Reserve has announced that it intends to hold down rates until at least 2014. If the Fed sticks to its plans, Treasuries could avoid losses for some time and funds that track the Barclays index may continue to thrive.

Federated Bond

Because of the uncertainties, it is particularly important to diversify bond portfolios. Investors should consider holding funds that track the Barclays index as well as investments that could prove resilient if Treasuries sink. For an active fund that does not track the Barclays index closely, try Federated Bond ( ISHIX). During the past 10 years, Federated has returned 7.1% annually, outdoing 96% of intermediate-term funds and topping the Barclays U.S. Aggregate by 1.4 percentage points.

Federated focuses on corporate bonds and holds few Treasuries. While most assets in the portfolio are rated investment grade, the fund currently has 30% of its holdings in high-yield bonds, which are rated below-investment grade. In contrast, the Barclays Aggregate does not include any high-yield bonds. Many investors may want exposure to high-yield bonds because they sometimes rise when Treasuries fall.

Federated portfolio manager Joe Balestrino varies his asset allocation as economic conditions change. When default risk increased during the financial crisis, he emphasized higher quality bonds and shifted away from shakier high-yield issues. Lately he has been adding high-yield bonds, which yield around 7%, an attractive payout at a time when 10-year Treasuries yield 2%.

Balestrino says that high-yield issuers have been reporting strong profits and solid balance sheets. He figures that the economy should continue growing, providing a healthy environment for high-yield bonds.

"We are not likely to see a recession in 2012, and default rates should remain low," he says.

Pioneer Bond

Another fund with a big corporate stake is Pioneer Bond ( PIOBX). During the past 10 years, the fund returned 6.3% annually, outdoing 85% of intermediate-term funds. Portfolio manager Kenneth Taubes lowered risk in 2008 and put 20% of assets in Treasuries. Since then he has shifted to corporate bonds. The fund currently has 14% of assets in high-yield bonds and 26% of assets in bonds that are rated BBB, the lowest investment-grade rating.

Taubes is willing to make contrarian moves. When municipal bonds sank at the end of 2010, he began buying. At the time investors were dumping municipals because of fears about defaults. But the bonds soon revived, and Taubes scored nice gains. "We bought issues from top-rated universities that were not going to default even if the economy was weak," he says.

Baird Aggregate

For a steady fund that sticks closely to the Barclays benchmark, consider Baird Aggregate Bond ( BAGIX). The fund returned 5.9% annually during the past 10 years, outdoing 74% of competitors. Baird currently has 54% of assets in bonds that are rated AAA or AA. The portfolio has 21% of assets in BBB bonds, which yield around 4%. That is a solid yield for bonds that come with limited risk, says portfolio manager Charles Groeschell.

The Baird managers search for undervalued bonds. But instead of making bold trades, the managers aim to make small moves that can enable the fund to outdo the Barclays benchmark over the long term.

"Our assignment is to control risk and deliver consistent performance," says Groeschell.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.