BOND funds as a group outperformed stock funds last year, though not in the fourth quarter. And despite the bond funds’ less-volatile performance, choosing one is scarcely a piece of cake.
Last year, markets were constrained by multiple storm clouds: high unemployment in the United States, gridlock in Washington over the nation’s debt and tax laws, and a continuing fear of European contagion stemming from crises over sovereign debt in Greece, Portugal, Italy, Ireland and Spain. No one foresees a quick solution to any of these problems, and that makes it hard to invest for both a solid return and protection of principal.
Over all, Morningstar says, the average taxable bond fund returned 2.1 percent for the quarter and 4.6 percent for the year. In contrast, the average general stock fund surged 10.8 percent for the quarter but lost 1.7 percent for the year. But achieving high bond returns in 2012 may be more challenging.
Nevertheless, Eric Jacobson, director of fixed-income research at Morningstar, said he saw promise in some emerging markets because of “their structural reforms, growth rates and underlying fiscal health.” And there is value in some of these markets, he said: “The sell-offs in the fall actually made some of those markets even cheaper than they were earlier in the year.”
In 2011, municipal and high-yield bond funds, especially, turned in strong performances. And because Treasury and investment-grade corporate yields have both been low, that trend is expected to continue. But in choosing a fund, investors are advised to look for careful risk management and portfolio selection.
Kevin R. Lorenz, who manages the TIAA-CREF High Yield fund, described his approach. He and his team do fundamental research to look for good companies with strong cash flow, he said, generally choosing securities with the better ratings in the high-yield category that meet his criteria.
A vital part of risk management, Mr. Lorenz said, is to avoid any issuer that might default. As a result, he eschews the junk portion of the high-yield market, where default risk is relatively high. He also invests only in dollar-denominated bonds, avoiding currency risk. “U.S. corporates are strong,” he said. “Assets are underpriced.” He says he expects good returns for investors with a four- or five-year horizon, but he calls the short-term picture unsure, with volatility ahead.
Mr. Lorenz, who has 24 years of experience, advised investors to study five-year total returns in selecting a fund. At present, that includes both a very bad year for high yield, 2008, and a very good one, 2009, so there is an unusual opportunity to see a fund’s overall performance.
Jason T. Thomas, chief investment officer at Aspiriant, a national fee-only wealth management firm, said it was currently focused on municipal bonds, especially high-yield ones, for the bond portion of portfolios. Carefully selected issues offer great value, he said, and are relatively cheap, with yields equivalent to after-tax yields of 7 to 9 percent.
For fund investors, he likes the Nuveen High Yield Municipal Bond fund, which has recently performed well despite keeping down the duration of its holdings — a move that has reduced interest rate risk.
Guy J. Benstead, a portfolio manager of the Forward Credit Analysis Long/Short fund, which Morningstar classifies as a nontraditional bond fund and is based in San Francisco, said he had a “flexible mandate to seek out opportunities.”
Mr. Benstead, too, is overweighting municipal bonds. About 85 percent of the fund is in munis, with the remainder in corporate bonds and preferred stock. It sells short other corporates and Treasuries.
He said his fund uses leverage, borrowing at low rates to increase returns, a practice that has “inherent risk.” But, he added, “we have the tools to address and mitigate risk.”
MR. BENSTEAD predicted that the overall bond market wouldn’t fare as well in 2012-13 as it did in 2011, adding that his outlook for the economy, both in the United States and globally, was “not optimistic.” That is partly because of the European debt crisis, which he expects will lead to fiscal austerity in many countries.
Kurt Brouwer, chairman of Brouwer Janachowski, an investment management firm in Tiburon, Calif., said that a recession was possible but that he expected the economy “to muddle through” with a “pretty good” environment for bond funds. Still, he warned against seeking the highest yield, which he said would inevitably lead to more risk, or choosing funds tilted toward long-term bonds.
Mr. Brouwer said his clients had quite a bit of money in bond funds, including two Pimco funds — its Total Return and its Unconstrained Bond fund, as well as in the DoubleLine Total Return Bond fund, which has only a two-year history. Mr. Brouwer called the fund’s manager, Jeffrey Gundlach, formerly with TCW, “a super bond manager.”
Not every manager is enthusiastic about bond funds. Michael Stolper, head of Stolper Company, an investment manager in San Diego, said stock dividend yields, relative to bond yields, “would suggest a strong tilt toward equities and away from bonds and bond funds.”
Mr. Stolper predicted that someday, perhaps soon, the “new normal will be trend-line economic growth of 2 percent or greater,” leading to higher stock prices and dividends, as well as higher interest rates. With that, he continued, prices of bonds and bond funds will decline.
Nevertheless, he conceded that bonds “are useful in a low-interest-rate environment, primarily to temper the volatility of equity markets,” which, he said, could decline 50 percent at any time because of economic or political events — “and take years to recover.”
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