NEW YORK (Thestreet) -- Most bonds sank last year. Rising interest rates triggered the losses. When rates climb, investors dump existing bonds in favor of new issues with higher yields.
The difficult fixed-income markets hurt balanced mutual funds, which typically hold a mix of stocks and high-quality bonds. But some balanced mutual funds proved relatively resistant. The winners diversified their fixed-income holdings, including such assets as cash, high-yield bonds or convertibles. Those stayed in the black.
Top-performing funds include Delaware Dividend Income (DDIAX), Hotchkis and Wiley Capital Income (HWIAX - Get Report), and Sentinel Balanced (SEBLX - Get Report). If rates rise again this year, the wide-ranging balanced funds should again outdo most competitors.
A steady performer is Hotchkis and Wiley Capital Income. Holding a broad mix of assets, the balanced fund can be a stable core holding that provides income and limits losses in downturns. During the past year, Hotchkis and Wiley returned 19.5%, outdoing 97% of peers in Morningstar's moderate allocation category. The fund yields 3.6%.
Though it can hold a sizable stake in investment-grade bonds, the Hotchkis and Wiley portfolio currently has 95% of its fixed-income allocation in high-yield bonds, which are rated below-investment grade. High-yield bonds currently yield 5.4%, a decent payout at a time when 10-year Treasuries yield 2.8%.
"High-yield bonds come with some credit risk, but they generate more income than you can get with investment-grade bonds," says Hotchkis and Wiley portfolio manager Patrick Meegan.
In 2013, high-yield funds returned 6.9%, a healthy showing in a year when the investment-grade bonds of the Barclays Capital U.S. Aggregate index lost 2.0%. Rising interest rates can provide a headwind for high-yield bonds, but during periods when the economy is growing, investors often bid up prices of high-yield bonds because there is less risk of default. High-quality bonds, which present little default risk, do not necessarily receive a boost from an improving economy.
The Hotchkis and Wiley managers aim to overweight undervalued assets. When they do not lean toward any asset class, the managers keep half of their assets in stocks and half in bonds. With stocks struggling in 2011, the fund had 60% in equities. As stocks rallied, the fund gradually lowered its equity allocation to 56% of assets.
"Equities are becoming less attractive compared to high-yield bonds," says Meegan.
Delaware Dividend Income holds a mix that includes high-yield bonds and convertibles. Convertibles are bond-like instruments that can be converted to stocks. During the past five years, the fund returned 16.5% annually, outdoing 96% of moderate allocation competitors.
"We have been able to deliver most of the upside of the S&P 500 and offer some downside protection," says portfolio manager Babak Zenouzi.
In the turmoil of 2008, high-yield bonds and convertibles were crushed as investors dumped risky assets and shifted to the security of high-grade bonds. The Delaware managers scooped up depressed assets, putting half the portfolio in high-yield bonds and convertibles. As the securities rebounded, the managers trimmed their positions. The fund currently has 29% of assets in convertibles and high yield. Most of the rest of the assets are in dividend-paying stocks and cash.
In its fixed-income portfolio, Sentinel Balanced holds a mix of high-yield and investment-grade bonds. To protect the portfolio from rising rates in 2013, the fund managers kept 14% of assets in cash, which pays skimpy yields but holds it value. In addition, Sentinel used Treasury futures and other derivatives. By selling the futures short, the fund can produce profits when Treasuries fall. During the past five years, Sentinel returned 14.0% annually, outdoing 62% of peers.
Portfolio manager Jason Doiron says that interest rates could continue rising as the Federal Reserve tapers its stimulus program.
"To navigate the bond markets going forward, it will be prudent to use derivatives," Doiron says.
At the time of publication, Luxenberg had no positions in funds mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.