Is Your Bond Fund Reliable?

BusinessWeek's Scoreboard helps you find solid performers

The recipe for a good bond fund is simple -- low fees and reliable management. Finding a low-cost one is easy. But reliable management is another story because as everybody knows, cheap isn't always good. That's where BusinessWeek's Mutual Fund Scoreboard can help. We rate funds from A through F on their five-year risk-adjusted returns, so not only are you able to see which funds performed well but also which ones did so with the least amount of risk. Of course, our scoreboard also has critical data on sales charges and fees plus all the pertinent performance and portfolio information. To rate the funds, we start with those having at least five-year records and measure each one's monthly performance for the past 60 months. When a fund fails to beat the "risk-free" return of U.S. Treasury bills, it earns negative marks, which are subtracted from its total return. We then rerank the funds on these risk-adjusted results. Of 1,418 rated funds, only 105 received an A this year for their overall performance (taxable and tax-free funds are rated against each other). We also rate funds in their individual categories, such as international, high-yield, and convertibles, comparing them only with their peers. This year 96 funds received A category ratings, while 50 scored A ratings for their categories and their overall performance. For an interactive version of the entire scoreboard, go to bwnt.businessweek.com/mutual_fund/.

The funds that won As for both ratings deserve attention, and so do funds that got As for category ratings. Sometimes the top-rated funds are not available. GMO Emerging Country Debt IV (GMDFX ), for instance, is the only emerging-markets bond fund to get an A category rating, but it's closed to new investors. Next in line is PIMCO Emerging Markets Bond (PAEMX ), rated B+. That's still open. Manager Mohamed El-Erian aims to minimize the downside. "We monitor daily and carefully calibrate our exposure to credit risk, interest-rate risk, and liquidity risk," he says. Such precautions enabled him to avoid Argentine debt when that nation defaulted in 2001 and to weather 1998's Asian financial crisis with relatively modest losses.

JUNK PROFITS

Most bond investors, though, should own more diversified funds. Indeed, in this low-yield environment, a bond fund with a flexible investment policy might be just the ticket. Fidelity Strategic Income (FSICX ), for instance, typically holds 40% of its assets in high-yield bonds, 30% in U.S. government debt, 15% in emerging markets debt, and 15% in high quality non-U.S. debt. Still, portfolio manager Bill Eigen can adjust that mix depending on where he finds the best opportunities. In late 2002 he loaded up on high-yield bonds and lightened up on Treasuries. More recently he has been taking profits in junk. His reward: a high 9.6% five-year annualized return, which includes gains in the fund's share price. And with an expense ratio of just 0.80%, he doesn't have to assume steep credit risks to deliver an attractive 5.1% yield.

Michael Hasenstab of the Templeton Global Bond Fund (TPINX ) can also invest anywhere on the planet, but he can only buy government bonds. While interest rates are rising in many countries, which is bad for bond prices, he's buying in countries where rates are falling, such as in South Korea, Poland, and Hungary. Hasenstab can invest in U.S. bonds, too, but right now he's not. "There is better value outside the U.S.," he says.

Buying a fund for yield alone is probably the biggest mistake you can make. The elevated payout may be only temporary and may drop when the bonds mature. Even worse, the manager might be investing in securities that could easily default. "Even bonds of companies that have a 50-50 chance of going bankrupt are trading near par value," says Margaret Patel, who runs the Pioneer High Yield Fund (TAHYX ).

Manager Reid Smith of Vanguard High-Yield Tax-Exempt (VWAHX ) doesn't like chasing after yields either. But he doesn't have to, since his fund's 0.17% expense ratio is one of the lowest of all muni bond funds. "The fund doesn't have to reach for incremental yield, taking on greater risk with potentially disastrous results," says Smith.

In fact, despite the fund's name, BusinessWeek classifies it as an intermediate muni fund, not a high-yield muni, because, on average, its bonds are solidly investment grade. Still, the fund offers a healthy 4.6% pretax yield, which translates into 7.1% after taxes for those in the highest brackets. That's about the same as the taxable junk-bond fund, but this fund has far less credit risk.

Smith argues that the best opportunities in the bond universe are tax-exempts. He especially likes General Obligation (GO) bonds of states such as California and Massachusetts that are suffering budget problems -- problems he thinks will ease as their economies get back on track. Bonds of troubled states yield more, and the chances of default are slim. "The last state GO default was in 1841," he says.

Some managers take risk control to a whole different level. Christine Jones Thompson of the Fidelity Spartan Municipal Income Fund (FHIGX ) has 25 credit analysts, traders, and quantitative researchers constantly poring over her $4.6 billion portfolio. Every day she stress-tests her bonds under 12 separate hypothetical scenarios -- such as rising rates, falling rates, credit deterioration -- to see what impact they might have on the fund. "We may think that short-term rates will rise, and manage the portfolio accordingly," she says. "But equally important is knowing what might happen to the fund if rates don't rise as quickly as expected." That sort of analysis might prompt them to choose less rate-sensitive bonds. Such rigor has resulted in an impressive 7.6% five-year annualized average return.

Of course, there are many different kinds of risks. Investors in the five American Century Target Maturity funds on the A list don't have to worry much about defaults because their zero-coupon Treasury bonds are backed by the U.S. government. But such bonds are extremely sensitive to shifts in interest rates. For instance, American Century Target Maturity 2025 Inv. (BTTRX ), which owns securities maturing in that year, fell 20.7% when rates rose in 1999, then gained 32.7% in 2000 as rates dropped again. The past five years of falling rates have been a boon to this fund, but the next five might be a different story. Yet manager Jeremy Fletcher says the funds provide "predictable returns" to those who hold them until their maturity dates. "Investors know they'll get their money back," he says.

Target maturity funds might not work for all investors, but funds that protect your investment certainly will.

By Lewis Braham

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