Bond Funds That Should Lead the Pack

NEW YORK ( TheStreet ) -- Bond funds have faced headwinds this year. While the Barclays Capital U.S. Aggregate bond index has dropped 0.2%, long government bonds funds declined 3.0%, according to Morningstar.

The red ink can be traced to rising interest rates. Since the beginning of the year, yields on 10-year Treasuries have climbed from 1.78% to 1.96%. That has caused pain because bond prices tend to fall when rates climb.

But not all funds have suffered. Among the leaders lately are unconstrained bond funds. These have the freedom to buy a wide range of securities and employ strategies that can prosper when most bonds are sinking.

Using unconventional approaches, Scout Unconstrained Bond ( SUBFX) has returned 2.2% this year, while MetWest Unconstrained Bond ( MWCRX) returned 1.4%. Other funds that stayed in the black include AllianceBernstein Unconstrained Bond ( AGSAX) and Pimco Unconstrained Bond ( PUBAX). If interest rates continue rising in coming years--as many economists expect--then unconstrained funds are likely to remain near the top of the bond performance standings.

The unconstrained portfolios have the flexibility to shift holdings, emphasizing Treasuries one year and low-quality bonds the next. Lately many of the funds have held securities that are rated below- investment grade. The low-quality issues climbed in recent months as investors grew more confident that the risk of defaults was declining.

MetWest Unconstrained scored big gains with subprime and other low-quality mortgage securities. The securities represent pools of mortgages that were made to borrowers with credit problems. As homeowners pay interest and principal on their mortgages, investors in the securities collect income. The subprime issues became famous for their high default rates during the financial crisis. Frightened investors dumped the securities, which sold for 20 cents on the dollar at the market trough. MetWest portfolio managers became convinced that the markets had overreacted. While many borrowers would undoubtedly default, the securities had value because some homeowners would continue making payments.

Today the securities have rebounded from the lows, but the subprime mortgages continue to represent good values, says Stephen Kane, a MetWest portfolio manager. He says that the weakest borrowers have already defaulted. "The market is still assuming that defaults will continue at the same rates that we saw in the past, but conditions are improving," Kane says.

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