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By Jason Stipp and Eric Jacobson | 11-12-2013 04:00 PM

5 Bad Signs for a Bond Fund

These warning flags merit further investigation from bond-fund investors, says Morningstar senior fund analyst Eric Jacobson.

Jason Stipp: I'm Jason from Morningstar. Despite some outflows in recent times, we know investors still own a lot of bonds and increasingly maybe some different kinds of bond funds than they owned in the past. So, how do you know if your bond fund is one worth holding on to? Here to offer some bad signs for bond funds is senior analyst Eric Jacobson, from Morningstar.

Eric, thanks for calling in.

Eric Jacobson: Glad to be with you, Jason.

Stipp: You have a few signs that might give you pause if you notice them in your bond fund. It would be reason for further exploration. I find the first one pretty interesting. You say that a bad sign potentially for a bond fund is too much yield. I thought that’s what I was looking for when I was looking for a bond fund.

Jacobson: It's one of those things that is a signal of risk that you are taking, rather necessarily than return potential. I think that’s unfortunately one of the things that confuses a lot of people because they think that yield is what they are going to get. But in the context of a fund investment where the price of your investment can actually go up and down, the yield is really just what the fund is paying out at this particular moment in terms of income or, in the case of the way we publish a lot of the data at Morningstar, what the fund earned over the last 12 months.

It doesn't account for what's going to happen to the price of your investment going forward. When you add that together with the fact that that income is usually tied--in fact, it's always tied--to how much risk you are taking on, you want to be careful because if you compare a bunch of investments together the one with the highest yield is almost by definition taking on the most risk.

Stipp: When you are looking for a benchmark on whether this fund's yield is perhaps unusually high, should I look at the category average for yield or how do I know what's maybe suspiciously high?

Jacobson: I would say more than one thing would be helpful. Certainly, the category average is a very good place to start. Depending on the kind of category you are looking at, there may or may not be a good benchmark for it, for example.

In the past, if you had a core bond fund, the place to look would have been the Barclays U.S. Aggregate Bond Index as we've talked about before and written in some pieces on Morningstar.com. The index is increasingly looking a little bit different than the average fund and vice versa.

So, it really does probably pay to look at the category average a little more carefully if you can.

Stipp: Eric, in today's environment, for a core bond fund, what kind of yield level would cause you to raise an eyebrow?

Jacobson: If you look at the median roughly of funds in our intermediate-term bond category, which is sort of the main home for core and what we might call core plus bonds that take on a little bit more sector risk, you are looking at just under about 3%.

There is a little bit of a range around that. Some funds certainly can justifiably yield more than that, but once you start to get into the mid-3's and higher, you want to understand what's going on. There may be very good reasons why a fund is yielding more. But you want to start to be careful once you get up in those ranges and at least, if you can, try to understand what's generating that extra income.

Stipp: Second potentially bad sign for a bond fund or one worth further investigation, you say, is concentration. So, having a lot of assets in one particular area of the bond market. Which specific kinds of areas or is it any area of concentration that might be a potential concern?

Jacobson: Sure. Well, it's not uncommon as a baseline just to say that you might have a fund with a lot of Treasuries or a lot of mortgages because they're government-backed and they're considered to be safer. There's nothing inherently wrong with that as long as you understand especially what the interest-rate risks of those portfolios look like. But as soon as you look in pretty much any other area, you want to start to see how much concentration you have, especially relative to the broader market.

So, you might, for example, see a lot of corporates in a core bond fund. Normally, once you get above 20%, 30%, now you're starting to look at something that's a bigger bet--not necessarily a bad thing by definition, but you're starting to take on more risk than other core funds, at least.

One area that--just as some examples that we've seen in the past--around the time of the credit crisis, one of the big most popular bets was commercial mortgage-backed securities. Now, those are a relatively small part of the market, but a lot of funds were barreling into this sector because it started to look cheap early on in 2008 in particular and then a lot of funds got caught flat-footed with that sector later on in the year, and they were just way overexposed.

Today, we're looking at areas that funds have had similar experiences with, and the big one in the last several months has been Puerto Rico, in the municipal-bond marketplace anyway. A lot of funds had taken on extra exposure to Puerto Rico because the island offers some tax advantages for funds--for certain individuals. Single-state funds, in particular, can supplement their income with Puerto Rico bonds because they're still tax-free in the states. But as soon as the commonwealth started to run into some financial stress--additional financial stress, I should say--over the summertime, that really created a lot of problem for funds.

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