It's been a tough year for bond managers. Returns are low and tightly bunched across sectors, underscoring the fact that fixed income has been a difficult area in which to shine. But some funds have managed to do just that.
Morningstar Inc., which bestows the Oscars of the fund world each January, recently identified a few of the top contenders in the fixed income realm. The award goes to managers with superior long-term track records who have posted outstanding results for the previous year and demonstrated strong commitment to their shareholders.
With bond yields low and few opportunities in the corporate market, "there have been relatively few ways for managers to distinguish themselves from the rest of the pack this year," said Scott Berry, an analyst with Morningstar. Returns have been clumped in a tight range, with the average short-term fund gaining just 1.2 percent and the average long-term fund rising only 2.6 percent.
The surprise of the year has been that long-term funds have done better than their short-term counterparts, although the Federal Reserve has been steadily raising interest rates for the last 15 months, from a 1 percent fed funds rate to the current 3.5 percent. Typically, long bonds are more sensitive to such hikes, but they haven't suffered as expected. This has contributed to a challenging environment for bond managers, said Mark Kiesel, a senior member of PIMCO's investment strategy and portfolio management group.
"This was totally unexpected and it has fascinated people, including us. Nobody could have predicted this," Kiesel said. "It's made for a challenging market in terms of predicting yields."
Of course, Kiesel notes, interest rates aren't the only thing bond managers monitor. There's also duration, their position on the yield curve and the quality of issues they hold. They watch volatility and can choose which sectors to invest in, from Treasuries, municipals and mortgages to corporate issues, TIPs, international and emerging markets and high yield. Finally, there's currency; will the manager be long or short the dollar?
"By having all these avenues, we can add value even in a very difficult market, independent of which way interest rates go," Kiesel said.
So, for skilled managers, there have been opportunities. When the general consensus was to avoid long bonds, some took a chance and held onto them, and were rewarded. For others, the credit downgrades of Ford Motor Co. and General Motors Corp. presented a buying opportunity. The automakers' bonds dropped dramatically following their initial downgrades in April, but they rebounded over the following months. Managers who got in at the right time were able to book gains.
Others benefited by dipping into less-traveled areas of the market, such as bank loans, which come with credit risk and require some extra research. High yield has also held up fairly well this year, though many analysts feel it's reaching the end of its cycle.
"One of the overall themes has been flexibility. Managers that were nimble enough to take advantage of these opportunities are the ones who have shined," Berry said. "They've been flexible, and in some cases they've been more creative than other managers."
Morningstar's short list of top performers includes previous fixed income managers of the year Bill Gross of PIMCO Total Return (PTTRX), Dan Fuss of Loomis Sayles Bond (LSBRX) and the team at Western Asset Core Bond (WATFX). A total of 24 funds met the criteria, including eight taxable and two municipal funds at Vanguard Group, which Berry said reflects the importance of low expenses when returns are tight and yields are paltry.
"Vanguard dominated, they blew away the screen... because of their low expenses," Berry said. "If a fund has low costs, it's an unbelievable advantage. If a mutual fund has an expense ratio of 0.5 percent, and it's competing against one with a 1 percent expense ratio, that half percent is nearly insurmountable in this environment."
Other front-runners include Jeffrey Gundlach of TCW Galileo Total Return Bond (TGLMX), who has focused his portfolio on mortgages, which he says offer superior returns with less credit risk; the strategy has worked in 2005, as the fund has outperformed its peers. Another top contender is the management team at Metropolitan West Total Return Bond (MWTRX), which has stretched to find opportunities in asset-backed securities and adjustable-rate mortgages.
Also on the list is Mark Vaselkiv, of T. Rowe Price High-Yield (PRHYX), who has gone outside the high yield market to take positions in beaten-down investment grade bonds - which is what Ford and GM were before they were downgraded to junk. This fund has continued to perform well since closing to new investors in 2004, though Berry points out it is unlikely to keep pace with its three-year trailing return of 13 percent.
Given where the market is going, bond investors who have reached into riskier areas in search of higher yields would be wise to trim their expectations and take a more cautious tack. Kiesel, of PIMCO, sees opportunities in emerging markets, particularly those that export to China, a good reason to focus on asset quality and pricing power in the period ahead.
"It's a good time for people to be more cautious and conservative in their bond portfolio," Kiesel said. "The big theme going forward is inflation risks are rising, the Fed is going to hike until they get to 4 percent and credit conditions will tighten. This is the time to batten down the hatches."
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