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Fund Spy

Five Bond Nuggets for the Fall Season

A few thoughts before taking an autumn rake to your bond portfolio.

1) Your Benchmark Is Worthless.
Well, maybe not if you're talking about niches like Ginnie Mae or Treasury funds, but when it comes to your core bond portfolio, the Barclays Capital (nee Lehman Brothers) U.S. Aggregate Bond Index just isn't going to do you much good. And for that matter, it hasn't been much use during the past couple of years, either. The index crushed most intermediate-term bond funds (the natural home of core bond offerings) in 2008, and it's choking on the dust of more than 90% of them so far in 2009. For one, the index has 19% in corporate bonds, while more than 80% of intermediate-term bond funds--most of which use "the Agg" as their official bogy--hold more than that. And now that Uncle Sam is backing Fannie Mae and Freddie Mac, that 19% corporate weighting and a sliver of securitized bonds are just about the only nongovernment exposure left in the index. So, a fund hoping to provide any diversification is understandably going to try to look different from that index, and most have long held bits of high-yield, nondollar, and securitized assets that are in one way or another absent or underrepresented in the benchmark.

2) Your Manager Knows It.
The less charitable view is that this all makes beating your benchmark a whole lot easier. If you've got a market-standard index chock-full of low-return government bonds and you've got the freedom to buy other things that will help you beat it, why rock the boat? Every bond manager knows it's a heck of a lot easier (at least before fees and in a bull market ...) to beat the U.S. Aggregate than it is for the stock jocks down the hall to outgun the S&P 500. If your manager is using the Aggregate, though, it doesn't mean he is lying or trying to put one over on you; rather, chances are that he is caught in a wave of inertia. The "Agg" has been the industry's lodestar for years and years, and it acts as the starting point for most discussions about the taxable-bond market.

In a perfect world, your bogy would have exposure to every market in which you might choose to invest and be weighted in the way a reasonable manager might view as neutral. Most indexes are weighted by outstanding issuance, though, and Uncle Sam is far and away the biggest borrower on the block. Even before he took over Fannie and Freddie, the Aggregate had very small weightings in the nongovernment sectors that managers could use to diversify. But while the government sleeves are naturally large, other sectors are also lightly weighted because they can be difficult to track or price. Barclays has strict inclusion criteria that are popular among those who want its indexes to represent the most liquid parts of the market. That also means the 19% corporate-bond weighting in Barclays Aggregate represents only 60% of the U.S. corporate-bond debt outstanding, according to industry trade group SIFMA*. The $50 billion or so of asset-backed securities in the index? That's about 3% of the total out in the marketplace.

3) Risk Is Back.
And you thought things were calming down. Well, we may be past the days of apocalyptic system failure. The trouble is that with so much of the market now dominated by government bonds, and the market much more focused on unemployment and the Fed's liquidity programs than the pace of government spending, the Barclays Aggregate yield is at a 3.7% level that has rarely been undercut in 35 years. Whether you want to call that a bubble or not, it's low enough that a tiny inflation scare could do a lot of price damage. And while high-yield debt looked mouth-wateringly cheap at the end of last year, it has rallied incredibly since then. The Barclays High Yield Index has an impressive yield of around 11.5% right now, but S&P just figured the current default rate at 10.2% and expects that figure to hit 13.9% by July 2010--if economic conditions don't get worse than expected. In either case, today's 11.5% yield will be tomorrow's mirage.

4) History Doesn't Repeat. It Rhymes.
Yes, there's clearly more risk in the market than at the end of last year, yet there are still areas that look more interesting and potentially attractive than they used to. It's been years, for example, since there was reason to differentiate among the 17 euro-denominated sovereigns, which used to trade almost in lock step--until the system nearly blew apart. It's true that those yields aren't much more attractive than U.S. government bonds today, but there's now a healthy yield spread of at least 175 basis points (1.75%) between the highest and lowest sovereign issues in the Morningstar Eurozone Bond Index. Some of the best deals, though, are most likely in the municipal-bond market. Barclays Municipal Long Bond Index recently carried a yield of 5.2% that is the taxable equivalent of a fat 6.9%--if you're in the 25% tax bracket and live somewhere with no state tax. If you're in the 33% federal bracket or higher and have a modest state tax of 3% of more, you're looking at a number comparable to at least 8%. Investors fearful of inflation may still not want to go whole hog in high-quality bonds, but those are hard numbers to pass up.

5) Fees Are Important. No, Seriously.
Hey--don't look away. For every one of you to whom that sounds like a cloying broken record, there are three more who nodded their heads for items one through four, only to shake them here because they think I'm a simpleton who drank too much Kool-Aid at the last Bogleheads' meeting. As far as they're concerned, phrases like "You get what you pay for" and "premium performance deserves premium pay" trump the silliness of counting basis points in a fund prospectus.

Here's a quick snapshot of why they're wrong. Reason one is simple, especially in the comparatively modest-return world of bonds, and it's called math. Every dollar you pay in fees is a dollar you don't get in returns. And while great managers--not just good ones--may deserve a few extra bucks for what they bring to the table, the margin of their greatness, and the extra dollars that it deserves, have been greatly exaggerated. We've looked at this before, both in data research and countless qualitative inspections, and once you get past a short list of great managers, the only way to consistently beat high fees is to take on more risk. Here's another way to look at it: Unless you're being serviced by one of the true greats, good bond-fund performance plus high expenses almost surely means that your bond portfolio is taking on more risk than you need to.

And for those of you who are still convinced that I'm a simpleton, I beseech you to at least go back and read Bill Gross' August 2009 Investment Outlook in which he refers to paying fees on the order of 1% an "extreme absurdity." And no, I don't think Bill Gross is infallible. Just right.

*SIFMA--Securities Industry and Financial Markets Association