NEW YORK ( TheStreet) -- Shareholders of Vanguard Total Bond Market Index ( VBTLX) have reason to be disappointed. In 2012, The Vanguard mutual fund returned 4.2%, compared to 7.0% for the average intermediate-term fund, according to Morningstar. During the past five years, Vanguard has lagged 60% of its peers. The poor showing is particularly notable because the mutual fund has $120 billion in assets and ranks as the biggest passive bond fund. Will the index fund continue lagging actively managed competitors? Probably. The problem is that the Vanguard fund has most of its assets in government bonds. Those are likely to lag if the economy keeps growing and interest rates rise.
Government bonds could suffer a particularly steep fall because of the actions of the Federal Reserve, warns Howard Greene, portfolio manager of John Hancock Bond ( JHNBX). Under its quantitative easing programs, the Fed has been buying billions of dollars worth of Treasuries and government-backed mortgage securities each month. That has temporarily propped up prices of government issues. "As long as the Fed keeps buying a lot of the new issues, the bond benchmark may be able to hold up," Greene says. "But after a while, the buying will stop, and the game will be over." Investors are not being compensated for the risk of Treasuries, portfolio managers argue. The Treasuries in the Barclays benchmark yield a puny 0.90%. Overall the Vanguard fund yields 2.6%. To get a higher yield and more protection from a decline in Treasuries, consider an actively managed fund with a big stake in corporates and a long track record for outdoing the benchmark. Top choices include Janus Flexible Bond ( JANFX), John Hancock Bond, and MFS Bond ( MFBFX). Holding 89% of its assets in corporate bonds, MFS Bond yields 4.2%. During the past five years, the fund returned 8.4% annually, outdoing 95% of intermediate funds.
During the financial crisis, government-backed mortgages held their value, but securities with no agency support sank sharply as investors worried about the high levels of defaults on subprime mortgages and other shaky assets. Figuring that the market had overreacted, Greene began scooping up mortgages that sold for 30 cents on the dollar of assets. As defaults declined, prices rallied to more than 70 cents on the dollar. "When the housing market bottomed, the valuation of the mortgages shot up," Greene says. He still has 7% of assets in nonagency mortgages. These days the securities still yield 4% or more, a tempting yield for relatively safe investments. Follow @StanLuxenberg This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.