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American Funds' Quietly Effective Bond Funds

We survey the bond-fund landscape at American to find some winners.

Paul Herbert, 05/22/2006

Below is an article from the March issue of the Morningstar Fund Family Report on American Funds, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities. To review a risk-free trial issue of our Fund Family Report on American Funds, click here. Fund Family Reports on Vanguard and Fidelity Funds are also available.

Although few shops are more well-known among mutual fund investors, it's clear that American Funds is not the first name that comes to mind when it's time to buy a bond fund. But while its lineup may not have the complicated strategies that PIMCO offers or the ultralow costs that Vanguard features (or the broad array of options that each shop brings forward), American has enough strong points to make it worth your time to consider fitting one or more of its bond mutual funds into any portfolio.

Slim Lineup

The bigger shops build their lineups with the goal of being all things to all people. This emphasis probably comes from the fact that they cater to institutional clients, organizations that may demand products for more-narrowly focused needs, such as absolute-return or asset-liability matching strategies.

With American, which is more focused on retail investors, you get a rather svelte collection of five taxable-bond mutual funds and six tax-free funds. On the taxable side, for example, your choices include a government-securities fund, two general investment-grade funds, a high-yield fund, and a world-bond fund. On the muni side, the choices are three single-state funds--for investors in California, Virginia, and Maryland--two general muni funds, and a high-yield muni fund.

I don't view this limited assortment of funds as a drawback. True, investors who want to spice up a portfolio with a TIPS fund or a bank-loan fund will have to go elsewhere. But most investors probably need just one or two fixed-income funds to help them meet income and stability goals. Besides, it appears to me that American is sticking with what it does best. Nine of the shop's 11 funds boast 10-year trailing returns that top the gains of the median funds in their Morningstar categories.

Emphasis on Credit Research

Just like on the stock side at American Funds, and consistent with the firm's belief in in-house research, a broad team of managers, analysts, and traders supports the bond funds. In fact, an organizational chart from Capital Research & Management's fixed-income effort looks a lot like those you'll see from much larger fixed-income specialists, with a small army of folks divided into groups along sector lines.

The difference between American and a lot of other shops is that the list of individuals who spend time on credit research is much longer than the lists of those working in other areas. As Morningstar senior fund analyst Eric Jacobson points out, as many as 27 investment professionals contribute to American High Income Trust AHITX.

Again, as on the equity front, the firm's forte in bond-land is evaluating companies: digging through their financial statements, assessing their management teams, and gauging the sustainability of their competitive advantages. And this credit focus carries over to funds like intermediate-term bond offering Bond Fund of America ABNDX, which recently devoted nearly half of its portfolio to corporate bonds, including nearly 10% of assets to high-yield bonds. It's also evident in the fund's tax-free fund lineup, with funds such as Tax-Exempt Bond Fund of America AFTEX and Limited-Term Tax-Exempt Bond Fund of America LTEBX. These funds recently stashed about 20% of their portfolios in bonds rated BBB and lower, which we consider the riskier area of the muni universe.

We're sometimes skeptical of funds that sport relatively large weightings in low-quality fare--quite simply, they tend to be more volatile than funds that stick with investment-grade bonds and may swoon when credit conditions sour. It's certainly the case that many of American's offerings have treated investors to more ups and downs than similar rivals have, but the depth of the firm's research and the decision to diversify the funds across many individual issues have generally kept the funds from running off of the rails in the worst of times. And at other times, they've delivered handsomely. I think the benefits of the firm's emphasis on lower-quality bonds generally outweigh the drawbacks.PAGEBREAK

Low Fees

It's hard to beat Vanguard on fees, but for investors who are limited to investing in load funds, American Funds gives you a darn good deal. Consider that you pay 0.65% of assets in annual expenses for the front-load shares Bond Fund of America--a full 25 basis points (0.25%) less than you are expected to pony up for the similar share class of PIMCO Total Return PTTAX. And Bond Fund of America is also quite a bit cheaper than similar load funds from other standout operations, such as Fidelity and BlackRock.

This cost advantage extends across the firm's bond funds. In fact, the front-load share class for each of American's 11 offerings has an expense ratio that lands in its Morningstar category's cheapest quartile. I think American could charge less for U.S. Government Securities AMUSX, which is more costly than every other fund in the lineup (save the globetrotting Capital World Bond CWBFX), but in general, the shops I named above could learn a lot from American when it comes to pricing their funds. Of course, with lower fees, shareholders get to keep more of a fund's total returns for themselves.

Big Funds

There are two sides to every coin. So while I like the fact that American has had the ability to hire and retain a large staff of credit analysts and offer its funds with attractive price tags, it's worth making clear that these positives might not have been possible if the funds were smaller. Bond Fund of America's asset base checked in at nearly $23 billion recently, and American High Income Trust tipped the scales at more than $10 billion as of Feb. 28, even though it, like many other high-yield mutual funds, hasn't enjoyed much in the way of inflows lately.

I've discussed how I think size could impede American's stock funds in the past, but this case is a bit different--and generally less disturbing--in the fixed-income sphere. One reason is that the markets for many varieties of fixed-income securities are very liquid. For instance, the secondary market for U.S. Treasury bonds is the most liquid in the world.

It can get trickier in the high-yield sector, though. New high-yield offerings often come to market in increments of a few hundred million dollars apiece. Given its own choosiness in picking issues, the large number of high-yield buyers in the marketplace, and any given manager's desire not to own too much of any issue, American will receive allocations that are at most one tenth the size of the deal. But orders of such size represent tiny portions of the fund's asset base, and the managers will have to find more of them to help performance. (And depending on market conditions, management may have to shop for new purchases on the basis of size in addition to fundamental criteria.) Some high-yield funds we admire have closed at smaller asset levels to try to better manage this situation.

At the end of the day, despite these concerns, we think astute investors can find some winners among American's offerings.

Paul Herbert is a senior analyst with Morningstar.

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