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The Not-Ready-for-High-Yield Players

Use this screen to find intermediate-term and multisector-bond funds for investors who are wary of high-yield funds.

Karin Anderson, 08/03/2009

The high-yield bond market's recent rally has been hard to ignore--the typical fund in this category has returned 22.5% for the year to date through June 18, 2009. That said, the category as a whole was down 26.4% in 2008, and factors including climbing default rates and potentially lower recovery rates for bankruptcies mean that the likelihood for continued volatility is high, and another high-yield sell-off is entirely possible if the economy continues to flounder.

Investors not ready to add a pure high-yield offering to their portfolios would be better served by sticking with an intermediate-term or multisector-bond fund. While these funds might offer some exposure to high-yield issues, they also offer more diversification in terms of credit quality and sector allocations.

Creating a screen for topnotch funds in these categories is a snap with Principia or Morningstar Advisor Workstation.

Special Criteria = Distinct Portfolios Only
And ( Morningstar Category = Interm-Term Bond
Or Morningstar Category = Multisector Bond )
And Purchase Constraints = Closed-New Investment

Simply screen for intermediate-term and multisector-bond funds that are open to new investment.

And% Rank Cat. 10 Yr <= 33
And Manager Tenure (Longest) >= 10.0

We limited the results to funds that ranked in the top third of their categories over the past 10-year period, making sure that the current management teams were responsible for the outperformance.

And Min Init Purchase <= 25000

Lastly, we required that the funds have investment minimums of $25,000 or less.

The funds that pass the screen include (as of June 18, 2009):

Metropolitan West Total Return Bond MWTRX
Managers Stephen Kane, Laird Landmann, and Tad Rivelle have successfully skippered this intermediate-term bond fund since 1997. During the 2009 Morningstar Investment Conference, Rivelle explained that his team has been finding some of the best opportunities among investment-grade corporate bonds and is only selectively hunting among higher- yielding issues including BB and B rated issues, as well as bank loans. A focus on residential and commercial mortgage fare in 2008 highlights the managers' contrarian bent, as these issues have been a drag on performance in the past year. Patience is required occasionally for this team's bets to pan out.

FPA New Income FPNIX
If the volatility in the high-yield bond market makes you too squeamish, FPA New Income won't cause you to lose any sleep. The fund has a stellar long-term record, and manager Bob Rodriguez has maintained a "buyer's strike" against high-yield bonds (as well as long-duration U.S. Treasuries) in recent years as a result of his top-down calls. Although Rodriguez is set to take a one-year sabbatical starting January, we take comfort in that he is handing the baton to his experienced comanager, Thomas Atteberry. Plus, Rodriguez is retaining his ownership stake in FPA and intends to return to the fund as assistant manager after his sabbatical.

TCW Total Return Bond TGLMX
Managers Jeffrey Gundlach and Philip Barach have navigated volatile mortgage markets over the past couple of years at TCW Total Return Bond with extraordinary skill. And while the team here has traditionally focused on collateralized mortgage obligation issues based on government agency-backed mortgage debt, recently it has ventured into more-adventurous segments of the market, and to good effect. For example, the duo has found compelling value in segments of the nonagency mortgage market (recently near 46% of assets), introducing credit risk to the portfolio, but they were purchased at distressed prices, and Gundlach argues that they offer strong total return potential even with continued mortgage market and economic stress, downgrades (of which there have been some), and defaults.

Managers Fremont Bond MBDFX
Bill Gross and his team at subadvisor PIMCO have delivered strong returns throughout the subprime-mortgage meltdown and subsequent financial crisis in 2007 and 2008 in large part because of a prudent approach to risk-taking, and that caution remains. Earlier than most, Gross and PIMCO saw trouble on the horizon for the housing sector, as well as the implications it could have for the economy, and they consequently maneuvered the fund to avoid the regions of the market most laden with credit risk. (Less than 2% of assets are rated below investment-grade). Instead, Gross emphasized issues with varying degrees of either explicit or implicit government support, such as agency-backed mortgage debt (recently, more than half of assets) or the short-term debt of corporations that carry FDIC guarantees.

Dodge & Cox Income DODIX
In the most challenging couple of years for the stock and bond markets since the 1930 founding of this fund's advisor, this fund still looks better than its category. Those relative results, however, belie a harrowing period. Since the credit crunch bloomed into a market- and economy-sapping crisis in October 2007, this fund at times has trailed its benchmark, the Barclays Capital Aggregate Bond Index, by its widest margins ever: more than 2 percentage points in 2007 and more than 5 in 2008. The fund's affinity for corporate bonds and aversion to Treasury securities (about the only thing that did well in 2008) explain much of the difference.

That's still a lot of ground to make up, but this fund is capable. It has low expenses, experienced managers, a consistent process, and a competitive long-term record--all factors that correlate with lasting success. The managers have adapted their approach a bit by paying more attention to the short-term liquidity of its holdings to ensure that they'll be able to meet obligations in this brutal economic environment. The fund remains focused on bonds with yields and prices to compensate investors for holding them for three to five years.

Pioneer Strategic Income A PSRAX
Veteran manager Ken Taubes' generally defensive stance helped the fund in 2008 compared with multisector-bond category peers. His underweighting to credit--particularly in the financials sector--and an overweighting to agency mortgages (more than a third of the fund was in this area) for most of 2008 provided a strong relative boost for the fund.

More recently, the fund has benefited from yet another timely move on management's part. During the sell-off in late 2008 and into the early part of 2009, management was adding a good deal of high-yield securities and investment-grade corporate bonds. For example, prior to the market meltdown in fall 2008, the fund had less than a fourth of assets in high yield and the percentage in investment-grade corporates was in the single digits. Now, the fund has more than 25% in investment-grade and more than 40% in high yield. Taubes also scooped up bank loans and convertibles.

Overall, for investors who are still skittish about the prospects for high-yield markets, these are all great options that still allow investors to gain exposure to talented management teams who are not only finding good opportunities, but for whom preserving capital is key. Another consideration, however, would be to enter the high-yield market via one of the more cautious mutual fund options, such as Harbor High- Yield Bond HYFAX, run by the Shenkman Capital Management team. The fund held up much better than the typical fund in the category during last year's tumultuous market.

Karin Anderson is a mutual fund analyst with Morningstar.

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