Lies, Damn Lies, and Category Rankings

Throw the first-quarter bond-fund category averages out the window. History will show the average ultrashort fund lost 1.9% during the quarter and that the average intermediate-bond fund more or less broke even. But only a handful of ultrashort funds lost more than 2.0%, and many intermediate funds did much better or worse than break even. What we're seeing in these bond-fund categories and others is dramatically wide, and even unprecedented in some cases, dispersions between category winners and losers. And when the returns are all totaled up and averaged together, we get an output that looks quite tame relative to the extreme inputs.

The dispersions have largely been caused by issue- and sector-specific subprime-related trouble combined with a broad flight to quality. The issue- and sector-specific problems have caused huge losses for certain funds, mainly in the ultrashort category of all places, while the flight to quality has spurred a tremendous rally in Treasuries and other government bonds. The flight to quality has also punished bonds with even a hint of credit risk. Indeed, funds that hold large allocations to government securities, such  Evergreen Adjustable Rate  and  Vanguard Intermediate-Term Bond Index (VBIIX), have migrated up the charts, while those owning exposure to subprime mortgages, asset-backed securities, and/or mid- and low-quality corporate bonds (think funds such as  Schwab YieldPlus  and  Fidelity Ultra-Short Bond ) have sunk to the back of the pack.

And for many funds, the extreme returns we've seen recently are likely to impact their category rankings for years to come. It would seem logical to assume that three or four good years would make up for one bad year. Indeed, taking a straight average of four top-quartile rankings and one bottom-quartile ranking places a fund firmly in a group's top half for a five-year period. But the math doesn't always work out that way. For example, a fund could squeeze into the top quartile of the ultrashort category in recent years by outperforming its average peer by less than half of 1 percent, as Fidelity Ultra-Short Bond did in 2005 and 2006. But if that same fund underperforms the next year by 5 full percentage points, as Fidelity Ultra-Short did in 2007, its five-year ranking will drop like a rock. Indeed, the Fidelity fund's five-year ranking now stands at a lowly 96th percentile.

Such extremes can make it difficult to judge a fund's success or failure. It's easy to say funds with huge losses have been failures, but when those losses knock the category averages out of whack, other funds can look better or worse than they actually are. For example, funds can actually outperform the category as a whole while ranking in the category's bottom half. In fact,  Wells Fargo Advantage Ultra Short-Term Income   outperformed its average ultrashort category peer by 1 full percentage during the first quarter of 2008 while underperforming more than half its category peers. You could say that the fund had a successful quarter because it avoided the big losses that stung some peers, but you could also say the fund failed, in that it underperformed more than half of its category rivals.

So how is one to measure the success or failure of bond funds in 2008? Investors can start by looking at funds' returns relative to those of appropriate benchmarks. Each fund lists a benchmark in its prospectus, and Morningstar lists broad asset class benchmarks on each fund's Total Return page. For the intermediate-bond category, the Lehman Aggregate Bond Index (2.2% return for the quarter) is a great place to start. For ultrashort funds, there is no gold standard, but many funds use short-term Treasury indexes, such as the Merrill Lynch 1-Year Treasury Index (2.1%). Both are investment-grade indexes, so they may not be appropriate for funds that invest in mid- and lower-quality bonds. Still, looking across a variety of indexes, a 1.5% to 2.0% return looks like a good first-quarter hurdle for most diversified investment-grade bond funds. Funds that topped that mark look to be on pace for a good year from both an absolute and relative standpoint.