Intermediate-Term Bond Index Beaters

Up to now our Index Beaters series has focused on equity-fund categories in an effort to identify those actively managed funds that have outperformed indexes during medium (five-year) and long (10-year) periods. Previous installments focused on foreign, mid-cap, and large-cap equity funds. This week we turn to fixed income and a category that has enjoyed huge asset inflows during the past year: intermediate-term bond.

Morningstar defines intermediate-term bond funds as those with portfolios of investment-grade U.S. issues, typically with durations (a measure of interest-rate sensitivity) of 3.5 to 6.0 years. During the past year, investors have continued to plow money into bond funds while turning away from stocks, and no fund category has seen more inflows than intermediate-term bond, with $106.7 billion added in the 12-month period ended Sept. 30. To put that into perspective, consider that intermediate bond, at $1.06 trillion, is the second-largest mutual fund category by net assets (behind only large-blend stock), and that about 10% of those net assets were added in just the past year.

Benchmarking a bond fund against an index isn't quite the same as benchmarking a stock fund. For one, bond investors often focus more on yield than price appreciation. However, it's a bond fund's total return (which includes yield) that best reflects an active fund manager's abilities. To benchmark the performance of intermediate-term bond funds, we used the Vanguard Total Bond Market Index (VBMFX) fund, a low-cost offering that tracks the Barclays Capital U.S. Aggregate Float Adjusted Index, a proxy for the investable U.S. investment-grade bond market.

Once again, we turned to Morningstar's Premium Fund Screener tool, this time to look at actively managed intermediate-term bond funds in our database that have 10-year track records. We included institutional funds and those currently closed to new investors to capture the broadest possible list. Of the 215 that qualify, about half outgained the proxy during the trailing five- and 10-year periods. That's notable in that it is by far the best outperformance ratio among active managers versus the benchmark so far in our series. One possible explanation for this is the fact that, since the financial crisis of 2008, intermediate-term bond-fund managers have been willing to venture away from the benchmark, giving them room to outperform. They've also taken on more risk than our index proxy, which carries a below-average Morningstar Risk rating versus the category. This lower risk profile served Vanguard Total Bond Market Index well in 2008, when it outperformed the intermediate-term bond category by nearly 10 points. Also keep in mind that our screen does not include intermediate-term bond funds that no longer exist. It's possible that the percentage would be somewhat lower if those were included.

To find funds in this group that have been vetted by our bond-fund analyst team, and that new investors may have an interest in, we screened out institutional funds and those that are closed to new investors and searched for those that carry Morningstar Analyst Ratings of Bronze or better. Premium users can see the full list here. Below is a sampling.

Metropolitan West Total Return Bond (MWTRX)      
5-Year Annualized Return: 8.6% | 10-Year Annualized Return: 8.3%
This fund had a lackluster 2011, in which its exposure to financial corporates and junk bonds led to a bottom-quartile performance, but it has rebounded nicely so far this year, beating its peers by 3.5 points (as of Oct. 23). Morningstar fund analyst Miriam Sjoblom says the fund's managers can employ a broad variety of moves, including duration bets, yield-curve adjustments, sector rotation, and issue selection, focusing on areas where they think research gives them an edge. They're not afraid to take on credit risk, either, as shown by the fund's 11% stake in issues rated below B (as of June 30; the category average is less than 0.5%). The fund's top 5th percentile annualized returns during the trailing five- and 10-year periods reflect its long-term success.

Loomis Sayles Investment Grade (LIGRX)    
5-Year Annualized Return: 7.8% | 10-Year Annualized Return: 9.5%
It might not offer the smoothest ride, with management that's unafraid of taking on credit and currency risk, but this load fund has delivered. Morningstar fund analyst Michael Herbst says the fund's veteran management team, led by Dan Fuss, takes a bargain-hunting approach, looking for securities and currencies it believes are undervalued. The fund goes light on Treasuries while holding about 70% of assets in corporates (as of Aug. 31), more than double the category average. The fund carries a high Morningstar Risk rating, and during the past 10 calendar years it has landed in the top decile of intermediate-term bond funds six times and in the bottom quintile twice, most recently last year.

Dodge & Cox Income (DODIX)      
5-Year Annualized Return: 7.0% | 10-Year Annualized Return: 6.1%
This fund's managers also take a bargain-hunting approach, investing with a three- to five-year time horizon in mind and reducing interest-rate risk by keeping durations short (currently 3.5 years--more than a year less than the category average). At the same time, they seek out extra income, emphasizing corporate bonds, including high-yield fare. Despite the fund's lackluster recent performance--landing in the bottom half of the category each of the past two years--it still lands in the top one third of intermediate-term bond funds during the trailing five- and 10-year periods. Its 0.43% expense ratio, low for a no-load intermediate-term bond fund, is a plus.

Performance data as of Oct. 23.