As core bond funds color outside the lines in search of better
returns, conservative investors need to keep a close watch on their
Intermediate-term bond funds form the heart of many investors'
fixed-income holdings. Traditionally, these funds behaved much like
the Barclays U.S. Aggregate Bond Index, which is composed entirely
of high-quality U.S.-dollar-denominated bonds.
Since the financial crisis, however, many funds have delved into
high-yield "junk" bonds, emerging-markets debt, and other holdings
that play little or no role in the aggregate bond index. More than
one-third of intermediate investment-grade bond funds had more than
10% of assets in non-investment-grade debt as of mid 2012,
according to fund-tracker Lipper, up from 6% at the end of
While this non-investment-grade debt has generally performed
well recently, the trend raises concerns for investors. If there's
a major market downturn, core bond funds may not hold up as well as
investors are expecting. High-yield and emerging-markets bonds
"have a tendency to tumble when the equity markets have a problem"
and when credit standards are tightened, says Jeff Tjornehoj,
senior research analyst at Lipper. "That's the fear" for investors,
Many core bond funds began wandering outside their traditional
bounds in the immediate aftermath of the financial crisis because
riskier holdings had taken a severe beating and were available at
bargain prices. And although bond-market pricing has returned to
more normal levels, many managers have stuck with these more exotic
holdings because they offer decent yields at a time when safer
bonds have been yielding next to nothing. "There's a lot of
yield-chasing going on," says Eric Jacobson, senior analyst at
Jacobson's recent research illustrates the extent of
intermediate-term bond funds' migration away from their old home
turf. He analyzed how much of the funds' three-year rolling returns
can be explained by the returns of the Barclays Aggregate index,
using a statistic called R-squared. (An R-squared of 100 would mean
that all of the fund's movements are explained by the movements of
the index.) As of last November, the average intermediate-term bond
fund had an R-squared of about 70, down from just below 100 before
the financial crisis, he found.
Some core bond fund managers say they have found a way to
incorporate higher-yielding holdings without loading up on risk.
The MFS Bond fund (symbol MFBFX; Class A shares have a 4.75% load)
had about 16% of assets in high-yield corporate bonds at the end of
February. Most of that was in bonds rated BB, the highest junk-bond
rating. Because many institutional investors, such as pension
funds, don't buy below-investment-grade debt, and high-yield
investors often go after lower-quality fare, these bonds tend to be
unloved, says portfolio manager Robert Persons.
The fund focuses on BB bonds that its analysts believe are
actually investment grade, enjoying a price pop if the ratings
agencies ultimately upgrade them. In those cases, "we're buying
investment-grade companies cheap," Persons says. The fund lost
about 10% in 2008 but gained nearly 30% in 2009.
Study the Fund's Holdings
Conservative investors should consider limiting riskier holdings
such as emerging-markets and high-yield bonds to roughly 10% of the
total portfolio. While some fund families use the name "Core Plus"
for more aggressive funds and "Core Bond" for more traditional
funds, those labels don't always mean much. Some "Core Bond" funds
have more than 10% of assets in junk bonds, and some "Core Plus"
funds have well under 10% in high yield, according to Lipper.
To truly understand the funds' risks, investors need to dig
deeper. Enter the fund's name or ticker symbol at
and click the "portfolio" tab to see Morningstar's assessment of
the fund's interest-rate sensitivity and its allocation of assets
among bonds with various credit ratings. (Remember that BBB/BB is
the dividing line between investment-grade and junk bonds.) Also
look at the fund's yield and how it compares with other funds in
the category. "Yield is a great indicator," Jacobson says, because
a fund generating a higher yield "almost by definition has to have
Haven't yet filed for Social Security? Create a
personalized strategy to maximize your lifetime income from
Social Security. Order
Kiplinger's Social Security Solutions