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How to Spot a Bad Bond Fund

It's not that hard if you know where to look.

A version of this article appeared on on Nov. 13, 2013.

OK, so "bad" might be a little strong. It's difficult to point to any one or two factors and credibly argue that they alone make a bond fund bad. However, there are red flags that investors can watch for to help ferret out those bond funds that are likely taking on more risk of a blowup than others. The presence of one of these factors might be rightly interpreted as a reason to sit up and pay closer attention. If a bond fund flies multiple red flags, though, chances are that it's best left alone.

My Big Fat Yield
In a cruel irony, tantalizing yields may actually portend trouble. By most definitions, yield is a snapshot of how much income a fund is paying out on an annualized percentage basis, relative to its net assets. The most important axiom to remember, however, is that there is no free lunch. There isn't any extra source of return that  doesn't have some corresponding risk. Sometimes it's as obvious as big-time credit risk; sometimes it's as ephemeral as a dearth of liquidity. But it's always there. And of course, those funds that yield the most often attract a lot of investor attention. Try not to be sucked in. Funds that get into the biggest trouble are often those with the biggest yields. There's a strong correlation between how much yield funds have offered and how poorly they've performed during times of market stress. For example, funds with higher yields at the end of 2007 suffered meaningfully worse than low-yielding funds during the 2008 market meltdown.

What's concentrated? A fund's exposure to a single issuer? A single sector? A single state? Yes. Any or all of the above. In most cases, having too much of a good thing is no different than having all of your eggs in one proverbial basket. When the markets blew up in 2008, for example, a number of funds had taken on very large exposures to commercial mortgage-backed securities, and some did it with derivatives that caused even more trouble than managers expected when the sector began selling off. Oppenheimer Core Bond (OPIGX) had other bets that went sour that year, but its CMBS bet was so big that it took what was supposed to be a core bond portfolio and turned it into something very different. More recently, a number of muni funds had built up meaningful exposures to Puerto Rico prior to the island's debt selling off during 2013. It may not have seemed to be a red flag a few years back when the commonwealth boasted higher credit ratings, but tolerating concentration because of high ratings--such as those earned by many subprime-mortgage tranches prior to the financial crisis--has led to tears often enough.

Too Much Leverage
There was a time when it didn't even seem necessary to mention this. It was an article of faith in years past that open-end mutual funds simply didn't use leverage. Those years are gone. It's no reason to panic, but a lot of bond funds use leverage of some sort these days, an issue put in sharp relief during the financial crisis. Most people think of leverage as similar to margin borrowing. You start with a basic portfolio, borrow some money against it, and invest the borrowed assets to boost your market exposure. Doing so will almost always magnify your gains and losses, making your portfolio more volatile. That's not always bad, but the more leverage you use, the more risk you take. There's no rule that says how much is too much, but once you get in excess of 10%-15%, it's certainly worth taking a hard look at what's going on.

One tricky twist on this theme is that a portfolio can develop leverage by adding market exposure via derivatives, which usually require little or no money up front. Another is that some funds take on leverage via derivatives cautiously by using very short-term bonds to back them, with the goal of adding a small amount of risk in exchange for a thin layer of extra return. In just about every case, leverage is hard to identify, and fund disclosures can be really confusing. You often can detect run-of-the-mill leverage by comparing a fund's total investments with its total net assets; the higher that ratio is above 1, the more leverage there is. Leverage from derivatives is unfortunately much harder to decipher, as derivatives are often used for hedging or wind up offsetting each other. The best way to figure out if your fund is leveraged is to ask. If your fund company can't provide a satisfactory answer, that's its own red flag.

If there's a unifying theme here, it's to avoid extremes. If a fund purports to be of a certain ilk but actually looks a lot different from its peers, that's a red flag. The chase for bond-fund assets is notoriously competitive, and it's always tempting for managers to take on what may seem like a marginal amount of risk in order to make their wares look a little more attractive. For some, that temptation is too strong--and disclosure too weak--leaving investors saddled with funds that turn out to be much riskier than they expected.

The Usual Suspect
There's one more thing, and any habitual Morningstar reader already knows it: high costs. They're the one sure thing to eat away at returns, regardless of what else is going on in your portfolio. When it comes to bond funds, the presence of high costs can be especially insidious. Investors rightly judge their options based on how returns pan out after fees are taken into account. Managers who have to cope with higher expense ratios have added pressure because they start the race behind everyone else. When you're already behind, it's extremely tempting to take on more risk in order to just keep up. And we've already discussed where that temptation can lead.

Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.