Bond Fund Blues

Reprinted from Financial Planning Magazine, August 2008
Craig L. Israelsen, Ph.D.

ot all bond funds are created equal because not all bond fund managers are created equal. One of the primary differences between bond fund managers is their willingness to tap into lower rated issues. In recent years, such aggressiveness tended to boost performance. Recently, however, this less-than-AAA appetite has been a recipe for disaster.

Consider the wreck of Regions MK Select Intermediate Bond Fund (RIBIX). Among its peer group it was a top 10 performer in 2004, 2005, and 2006. Then in 2007, this fund lost 50.1% and was dead last among all 288 US intermediate bond funds. To put this meltdown into perspective, consider that the average intermediate bond fund had a return of 5.2% in 2007.

A bond fund losing over 50% in one year, how does that happen? The answer is straight-forward-risky ingredients (aka heavier exposure to sub-prime mortgages). Ironically, exposure to lower rated bonds provided a nice tail wind for some bond funds in 2004, 2005, and 2006. But alas, a tail wind (or excess return in a bond fund) may be a sign of an impending storm. The modestly higher returns of RIBIX during 2004-2006 were more than wiped away in 2007. In fact, by March 31, 2008 RIBIX had lost nearly 72% over the prior 12 months. Risking a dollar to win a dime didn't pay off.

Is the performance of RIBIX an anomaly? Yes, but only in its extremity. The 15 months from January 1, 2007 to March 31, 2008 have revealed which bond fund managers were playing with matches and which ones were not.

Consider the following: there were 288 intermediate US bond funds with a full five-year performance history by year-end 2007 (data source Morningstar Principia). This count includes distinct funds only, that is, only one share class was included for funds with multiple share classes. In 2003, 2004, and 2006 all 288 funds had a positive return. In 2005, 3 funds had a negative return, however the worst return was a loss of only -1.12%. Then, in 2007, seven of these 288 intermediate bond funds had a negative return. Sign of a storm coming? Indeed.

From April 1, 2007 to March 31, 2008 nearly 10% of this group of bond portfolios (27 funds) had a negative return. And the storm is not yet over.

Let's now examine the contents of the bond funds that sailed around the sub-prime storm as well as those funds that sailed into it. As shown in "Sub-Prime Ingredients" the top performing quartile of bond funds during the 12 month period ending 3/31/2008 were those that minimized their exposure to bonds with a BBB rating or lower. The average return of these 72 funds was 8.57% and not one of them had a negative return during this 12 month period. Interestingly, the 72 funds in the bottom quartile outperformed the top quartile funds during 2003-2006 for precisely the same reason they dramatically underperformed in calendar year 2007 and in the 12 months ending 3/31/2008: exposure to riskier bonds (see "Boom and Bust").

Sub-Prime Ingredients

288 Intermediate US Bond Funds	Total 12 Month Return from 4/1/2007 to 3/31/2008	Allocation of Portfolio by Credit Rating
		AAA	AA	A	BBB	BB	B	Below B
Average Performance of Top Quartile from 4/1/2007 to 3/31/2008    (72 Funds)	8.57	74.25*	7.94	8.36	6.22	1.33	0.68	0.03
Average Performance of Bottom Quartile from 4/1/2007 to 3/31/2008    (72 Funds)	-0.73*	55.51	6.90	12.20*	17.19*	3.63*	2.28*	0.60*

* indicates a statistically different mean at the 99% level of confidence

Boom and Bust

	12-Month % Return as of 3/31/2008	Annual % Return  2007	Annual %  Return  2006	Annual %  Return  2005	Annual % Return  2004	Annual %  Return  2003
Average Performance of Funds in Top Quartile from 4/1/2007 to 3/31/2008    (72 Funds)	8.57*	7.30*	4.00	2.01	3.91	4.55
Average Performance of Funds in  Bottom Quartile from 4/1/2007 to 3/31/2008    (72 Funds)	-0.73	2.41	4.75*	2.31*	4.59*	6.04*

* indicates a statistically different mean at the 99% level of confidence

The recent losses in a significant number of bond funds is a vivid reminder that the source of performance in a portfolio-whether bond or stock-needs to be understood in order to anticipate the potential risks. In the case of bonds funds, a portfolio with greater exposure to lower rated bonds presents greater risk. This greater risk is often masked, for a season, by higher returns. It will, of course, eventually manifest itself and when it does it may exact a higher price than the investor anticipated. Making matters worse, poor performance may initiate large scale redemptions from an underperforming fund which further exacerbate the fund's meltdown. This scenario has certainly played out for several bond funds recently.

Going forward, many bond investors will likely pay more attention to the quality of the holdings in the bond funds they select-as if credit quality is suddenly something to attend to? There is something very odd at work here, and it relates to the human tendency to downplay risks not recently observed and dramatically react to events most recently experienced. For instance, if we have the misfortune of driving by a terrible auto accident we tend to reduce our speed for awhile. But, within a short period of time, we're once again attempting to hit warp 7 on I-XX (fill in the blanks with the interstate highway closest to you). It's a form a recency bias-a well documented perceptual tendency in which we tend to overweight recent events and downplay events not recently observed. This behavior suggests that the memory of investors is rather short, and that within several years sub-prime notes (or whatever the financial steroid is at that time) will once again flow like IPO's during the 1990's, producing another educational experience in which investors re-learn the fundamental correlation between risk and return. However, those who choose to remember the bond fund experience of 2007-20XX will have learned-once and for all-that bond funds do carry differential credit risks based upon the credit quality of their holdings and that it pays to know what is under the hood of your bond fund.

A parting thought for thus who simply must drive fast. Choose a bond fund that focuses on quality and then choose a high-yield fund for your fixed income alpha rush. In this way, you at least know where your credit risk is located and can specify your exposure as you wish. As always, another alternative is to bypass bond funds altogether and purchase only highly rated individual bonds.

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Craig L. Israelsen, Ph.D. teaches family finance at Brigham Young University. He is a principal at Target Date Analytics LLC (www.TDBench.com) and author of "7Twelve", a guide to building diversified, multi-asset portfolios. To purchase a copy of 7Twelve, send an email to Jim Eccleston at jeccleston@snsfe-law.com.