Bonds went haywire in the first quarter. While high-yield securities dropped, many risky emerging market bonds stayed in the black. Some supposedly safe ultrashort funds suffered double-digit losses. At the same time, plenty of government funds returned more than 5 percent, an outsized result for such staid investments. Rarely have investors seen so many erratic moves in a single quarter.
The turmoil occurred as hedge funds and other investors raced for the safety of Treasuries and dumped questionable mortgage securities. Since the storm hit, bond markets have become calmer as prices of sub-prime mortgages and other trouble spots have stabilized. But the impact of the first quarter returns will weigh heavily on performance records in the future. Five years from now, funds that suffered big losses in the quarter may still rank at the bottom of their categories. This could occur because in the world of bond funds, only a percentage point or two may separate first-place finishers from also-rans.
Besides damaging fund reputations, the first quarter results could make some category rankings misleading, says Scott Berry, a Morningstar analyst. “You should not consider picking a fund just because it has beaten the category average,” Berry says.
Berry says that disastrous records by a handful of funds have pulled down category averages. So a fund can be above the category average even though it has underperformed more than 50 percent of its peers. He cites the example of Wells Fargo Advantage Ultra Short-Term, which outperformed its category average during the first quarter, but lagged most competitors.
Instead of focusing exclusively on category averages, investors should keep a close eye on how a fund has performed relative to its benchmark, says Berry. A good benchmark for ultrashort bond funds is the Merrill Lynch 1-year Treasury index, which gained 2.1 percent in the difficult quarter. Investors shopping for an intermediate-term bond fund may look for portfolios that outdid the Lehman Aggregate Bond index, which returned 2.2 percent in the quarter.
What's One Quarter Anyway?
Is it time to consider funds that fell apart in the first quarter and now seem to have recovered? Not yet, says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Waltham, Mass., that clears trades through Schwab Institutional. Tiku is particularly wary of ultrashort bond funds that blew up because they held sub-prime asset-backed securities. Portfolio managers bought the securities because they offered additional incremental yields that were as tiny as 5 basis points over the highest-quality debt. “There was no reason for fund managers to be involved in securities of that type,” says Tiku.
Funds that weathered the storm tended to emphasize high-quality issues. Below are some winners that seem poised to continue delivering steady results.
A conservative standout in the battered ultrashort bond category is Evergreen Adjustable Rate, which returned 1.45 percent in the first quarter, compared to -1.91 for the category average. Portfolio manager Lisa Brown-Premo looked at some sub-prime securities and decided to stay away. “We had credit concerns, particularly with the less- seasoned issues,” she says.
Going forward, the fund is likely to stay out of trouble. Brown-Premo focuses on AAA-rated mortgages that are backed by government agencies. Even when mortgages fall out of favor, such high-quality issues tend to hold their value.
As investors dumped mortgages, they also sold high-yield corporate bonds, which are rated below investment grade. The trouble pushed Franklin High Income into the red during the first quarter, but the fund managed to outperform most of its peers by a wide margin. Franklin avoids big losses by following an opportunistic strategy. While many funds emphasize a single segment of the high-yield market — such as relatively conservative bonds — Franklin hops around. Convinced that bonds had become cheap in 2002, the fund started buying issues with the low rating of CCC. That produced solid results as low-quality issues rallied. In 2006, Franklin began selling the shakier securities and buying steadier bonds with ratings of BB. “The valuations were starting to get rich, and there was too much risk in the lower-quality bonds,” says portfolio manager Eric Takaha.
The stronger high-yield issues suffered relatively small losses in the downturn. Now Takaha is again buying some lower-quality issues, figuring that prices have started to reach bargain levels.
Ducking Trouble In Emerging Market Debt
While many high-yield bonds dropped in the first quarter, the picture was more mixed for emerging market debt. Bonds from oil exporters such as Mexico and Russia avoided losses at a time when issues from Turkey and South Africa underperformed. In the volatile markets, MFS Emerging Markets Debt excelled by sticking with more conservative choices. “Because we were concerned about the global economic outlook, we pared back our positions in corporate debt and began buying sovereign bonds from countries with improving credit conditions,” says portfolio manager Matthew Ryan.
Ryan scored gains with bonds from Brazil, which recently received an investment-grade rating. Once plagued by out-of-control government spending, the country has tightened its belt and taken steps to bring down inflation.
A position in Latin American securities has helped T. Rowe Price New Income recently. An intermediate-term fund, New Income focuses on high-quality corporate and government bonds, but it can also move into high yield and foreign issues. Concerned about mounting problems in low-quality securities, portfolio manager Dan Shackelford began shifting to Treasuries in the summer of 2007. That helped the fund survive difficult conditions. More recently, the fund has been selling Treasuries. “Prices of Treasuries have been getting rich, so we have been moving into investment-grade corporate bonds and foreign issues, which pay attractive yields,” says Shackelford.
Another intermediate-term fund that dodged most of the trouble is Pioneer Bond. Besides avoiding sub-prime securities, portfolio manager Kenneth Taubes also underweighted bonds of financial companies, which slipped badly as investors became concerned about mortgage problems. “We stayed away from many banks because the standards for writing loans were clearly slipping,” says Taubes. Lately Taubes has been buying beaten-3down mortgages. By buying the unloved securities, he hopes to ride the eventual revival of the mortgage markets.
THE BEE GEES' FAVORITES
These bond funds outdid their peers durng the difficult first quarter.
| Fund | Ticker | Category | Three-year Return | Five-year Return | % Category Rank Five-Year Return | Maximum Front-End Load |
|---|---|---|---|---|---|---|
| Evergreen Adjustable | ESAAX | Ultra Short | 3.9% | 2.9% | 28% | 2.25% |
| Franklin High Income A | FHAIX | High Yield | 7.0 | 9.4 | 7 | 4.25 |
| MFS Emerging Markets A | MEDAX | Emerging Debt | 9.9 | 11.4 | 20 | 4.75 |
| Pioneer Bond A | PIOBX | Intermediate Term | 4.4 | 4.9 | 8 | 4.50 |
| T. Rowe Price New Income | PRCIX | Intermediate Term | 4.9 | 4.6 | 14 | 0 |
| Source: Morningstar. Returns through 4/30/08. | ||||||
