By Amey Stone
The case for making bond funds a serious part of your portfolio is looking better than ever. The bear market in stocks remains in full force, and since the economic recovery is turning out to be more tepid than hoped, worries early in 2002 that interest rates would soon start rising (bond prices move inversely to rates), have proved premature.
Meantime, the long-term results for many bond funds, which looked quite dull during the 1990s' bull run, are now shining -- especially in comparison to stock funds. The average U.S. diversified stock fund's five-year annualized gain is just 1.5%, while the average bond fund gained 5.4% a year in that time.
Some bond funds have done decidedly better than that. One example is the TIAA-CREF Bond Plus Fund (TIPBX ), a low-risk, intermediate-term fund that closely tracks the benchmark Lehman Brothers Aggregate Bond Index. It has delivered a healthy 8% five-year annual average return to its shareholders, outshining 94% of its peers, according to fund-tracker Morningstar. The average intermediate-term bond fund gained 6.5% a year in that time. This year, Bond Plus is up 7.2% -- 2.6 percentage points more than the average fund in its category.
TURNED TO TIPS.
Bond Plus is managed by Lisa Black, a 15-year TIAA-CREF veteran who has handled the fund, which now has $360 million in assets, since its inception five years ago. Bond Plus recently earned Morningstar's top rating, and Morningstar analyst Scott Berry credits Black with making smart moves among different fixed-income sectors.
For example, early this year Black shifted part of the portfolio into inflation-indexed Treasury bonds, known as TIPS, which have been one of the bond market's best-performing sectors. Black thinks the economic recovery is under way, and inflation, nearly nonexistent right now, will reappear at some point. As long as inflation climbs more than 0.92% a year, the value of the 2007 TIPS the fund owns now should rise, she says. She now has about 12% of the fund in TIPS.
Also in the first half of 2002, she emphasized mortgage-related bonds, which also outperformed, surprising many fund managers. As cash came into the fund, she let her exposure to these securities fall, which helped when those mortgage-backed bonds started to weaken this summer as another wave of refinancing started. "With rates so low and refinancing at nearly an all-time high, mortgages are going to continue to have trouble performing," says Black.
The key to the fund's success this year, says Black, "has been being real nimble in the corporate sector." She gives much of the credit to her team of credit analysts and traders who helped the fund cope with some of what she dubs the bond market's "problem children." The fund didn't own falling bonds like France Telecom, Mirant, and Calpine. It did hold WorldCom, which was rated investment grade until news of accounting improprieties hit the market. "WorldCom was a chink in our armor, but we made up for that on the corporate side with other moves," says Black.
She let her exposure to corporate bonds decline in the second quarter, but she has increased holdings in investment-grade credits recently. Black isn't yet adding to the high-yield sector, which makes up only about 1% of the fund, but she says she'll increase her exposure when the economy shows more strength, giving her the opening to take on a bit more risk.
One advantage Black's fund has over most of its peers is its low cost. TIAA-CREF doesn't impose a sales charge, and it has a piddling 0.3% expense ratio. That means a $10,000 investment would cost you only $30 a year.
"NEARING THE END"?
In contrast, PIMCO Total Return (PTTAX ), managed by star Bill Gross and one of the most popular bond funds in history, has a 0.9% annual expense charge and comes with about a 4.5% up-front sales charge. So, for that same $10,000 investment, it would cost $450 just to get in and $90 each year thereafter. Black's fund has shown lower volatility and just as strong results in the past five years: As of Sept. 10, Morningstar put both their five-year returns at 7.87%.
Morningstar's Berry warns that investors shouldn't chase returns by fleeing stocks in favor of bonds. "Bonds have already had a strong rally, and you don't know, but it may be nearing the end," he says.
Bond Plus, however, isn't overly exposed to interest rates. It has a duration (a measure of rate risk) of about 3.5% (a little less than the Lehman benchmark), says Black. That means if interest rates increase a percentage point, bonds owned by the fund could be expected to decline an average 3.5% in price. That amount should be offset by the fund's average coupon of 6%.
If rates spike, all bets are off. But with the economic outlook rather cloudy, that seems unlikely anytime soon. Many investors have learned in the past three years that bonds funds deserve a place in their long-term portfolios. With its minimal expenses, strong returns, and low volatility, TIAA-CREF Bond Plus has lots going for it.
Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column
Edited by Beth Belton