To outdo the Barclays benchmark, Wells Fargo aims to find bargain-priced bonds and overweight attractive sectors. While the index has 35% of assets in Treasuries, Wells Fargo only has 15% of assets in the sector. Instead the fund is overweight agency mortgage-backed securities. Those represent pools of home mortgages. While mortgages can default, the risk for investors is negligible because the securities are backed by the government and carry AAA ratings. Portfolio manager Troy Ludgood likes the agencies because they yield 80 basis points (0.8 percentage point) more than Treasuries.

The fund has 22% of assets in corporate bonds, including an overweight position in issues from REITs, companies that own portfolios of properties. Ludgood says that the outlook for REITs is improving, and the securities yield 200 basis points more than Treasuries. "Property values are in an upward trend," he says.

Touchstone Total Return is another fund that outperformed in 2008. The portfolio managers limited losses by steering away from shaky subprime mortgages. During the past ten years, the fund returned 5.9% annually.

Touchstone is currently underweight Treasuries and has 58% of assets in mortgage securities that are guaranteed by such government agencies as Fannie Mae and Ginnie Mae. The managers prefer mortgages for multifamily units instead of loans for single-family homes. The problem with the single-family securities is that the mortgages are prone to prepayments, which can occur when homeowners refinance, sell, or default. When prepayments occur, mortgage investors receive back their principal and must reinvest it at today's low rates. Prepayment risk can hurt prices of mortgage securities. Multi-family mortgages have less prepayment risk and provide the kind of predictability that the Touchstone managers prefer.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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