Seeking Yield, Bond Funds Ramp Up Risk

As core bond funds color outside the lines in search of better returns, conservative investors need to keep a close watch on their holdings.

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 2008.

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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, he says.

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 Morningstar.

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 Morningstar.com 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 more risk."

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