A Neutral-Rated American Funds Bond Fund That's Evolving

On Nov. 1, 2013, managers David Lee and Fergus MacDonald replaced former manager David Hoag on  American Funds Intermediate Bond Fund of America (AIBAX). Hoag left the fund to focus on his main charge,  American Funds Short-Term Bond Fund of America (ASBAX).

As on its equity funds, Capital Research has long used a multimanager approach to steer its fixed-income funds, with multiple managers independently overseeing sleeves of a portfolio. Yet that approach hasn't worked out very well for American Funds taxable fixed-income funds, with most of the funds in the lineup sporting average to below-average long-term returns versus their Morningstar Category peers. The multimanager approach remains intact, but the manager change at Intermediate-Term Bond Fund of America, or IBFA, reflects a number of steps the firm is taking to tighten up the coordination across its fixed-income operation. Walking through the fund's Neutral Morningstar Analyst Rating gives a glimpse into what's afoot.

All Together Now
In early 2013, the team's Portfolio Strategy Group, comprising a number of Capital Research and Capital Group's senior-most managers, began setting more-explicit portfolio positioning parameters for all American Funds' bond funds. Permanent members of the group include Mark Brett, who serves as principal investment officer for IBFA, and David Lee, who is taking over part of David Hoag's sleeve on IBFA, after having assumed increasing investment-grade credit-related portfolio management duties on other accounts since 2007.

The two other permanent members include Pasi Hamalainen, who since arriving from PIMCO in late 2012 has developed tools and processes to shine a brighter light on risk, and Bob Neithart, emerging-markets specialist on funds including  American Funds Bond Fund of America (ABNDX) and  American Funds Capital World Bond (CWBFX). There are three rotating members of the group: generalist veteran John Smet, who remains a manager on IBFA, mortgage- and asset-backed securities research analyst David Betanzos, and  American Funds American High Income Trust (AHITX) manager David Daigle.

The Portfolio Strategy Group now sets suggested ranges for all American Funds bond funds in areas including duration, curve positioning, inflation protection, credit, and sector weightings. At IBFA, Brett has leeway in applying the parameters to the fund's overall portfolio, but each of the fund's managers--Brett, Smet, Lee, and MacDonald, who has served as a manager on American Funds Mortgage 529 (CMFAX) and American Funds U.S. Government Securities (AMUSX) since 2010--must be headed in the same direction. For instance, the strategy group wanted to take on slightly more interest-rate risk as of Sept. 30, 2013, so this fund's effective duration of 3.2 years couldn't be shorter than the prescribed range relative to its Barclays U.S. Government/Credit 1-7 Year Ex BBB Index benchmark. In terms of interest-rate risk, IBFA still lands between American Funds Short-Term Bond Fund of America and  American Funds Bond Fund of America (ABNDX).

As of late, the strategy group also favored high yield over investment-grade credit, but because IBFA can't own high yield, that view translated into a slight overweighting to investment-grade corporate bonds in more-cyclical sectors. Far from handcuffing the individual managers, the strategy group's guidance should lessen the chance that individual managers' views at IBFA could cancel each other out within the overall portfolio. The strategy group has multiday forums each quarter to determine its views, and it meets formally twice a week between forums to revisit its suggested parameters and update them as the group's views evolve.

From the Inside Out
There's another aspect to this coordinated effort. At IBFA, Lee and MacDonald will each manage roughly 15% of assets, focusing primarily on corporate bonds and mortgages, respectively. That assignment plays to their respective expertise, and each has the flexibility to invest in U.S. Treasuries as well. Yet Lee and MacDonald are also tasked with weighing in on whether corporate bonds, mortgages, or government bonds offer the most attractive opportunities. By sharing assets between their two sleeves, the duo can essentially tilt the fund's overall sector weightings and also influence Mark Brett and John Smet, who manage more diversified sleeves of the portfolio. While Brett and Smet will continue to invest in a mix of U.S. dollar-denominated government bonds, corporate bonds, government mortgage-backed securities, and tiny slivers of commercial mortgage-backed and asset-backed securities, they'll likely take some of their cues from Lee and MacDonald's moves.

Capital Research is beginning to implement that model of specialist portfolio managers working alongside generalists in a more calculated way. Lee and MacDonald's intended role at IBFA reflects a more structured approach to portfolio construction than existed previously.

Why a Neutral Rating?
Increased coordination within each individual American Funds bond fund and across its entire fixed-income roster is promising. Yet IBFA's People, Process and Performance pillar scores, as well as its overall rating, remain Neutral. That's because there's not yet enough evidence to determine whether Lee and MacDonald's appointment or the Portfolio Strategy Group's guidance will give IBFA enough of a competitive edge to outperform its benchmark and short-term bond rivals on a risk-adjusted basis over a market cycle of at least five years.

The Portfolio Strategy Group and managers Brett, Smet, Lee, and MacDonald have got some proving to do. IBFA's annualized gains over the trailing three-, five-, and 10-year periods through Nov. 20, 2013, land in the short-term bond category's bottom third on a Morningstar Risk-adjusted basis. Over the trailing three- and 10-year periods, those gains lag the fund's Barclays U.S. Government/Credit 1-7 Year Ex BBB Index benchmark by 0.4% and 0.7%, respectively, while its 3.8% five-year annualized gain outpaces the benchmark by 0.3%. In three-year rolling returns over the trailing decade through October 2013, the fund lagged its benchmark 80% of the time but beat its average peer 92% of the time.

In some respects, those mixed results are consistent with what investors could reasonably expect from the fund's strategy. By hewing closer to its benchmark, the fund has taken on more interest-rate risk and less credit risk than most of its rivals in recent years. Those traits gave the fund a big boost in late 2011 when the markets turned risk-averse. But they've damped its performance amid credit's rally in 2009-10 and since early 2012, and they've contributed to the fund's bottom-decile, 1.0% loss for the year to date. That said, the fund hasn't consistently benefited from taking on more interest-rate risk over the longer haul, and missteps heading into 2008's crisis also stung. In theory, IBFA's relatively low expenses, which gets it a Positive Price pillar score, should enable management to deliver competitive results with less overall risk than more expensive funds, but IBFA hasn't capitalized on that advantage either.

The fund's protective approach to credit risk and extra helping of interest-rate risk both stem from its benchmark and will shape the fund's performance relative to its short-term bond peers. Even so, stronger performance relative its own bogy would be welcome.

What's Next?
The efforts outlined above for IBFA are also affecting other American Funds bond funds, namely the role of the Portfolio Strategy Group and a broader, firmwide risk-management effort headed up by Hamalainen and Chris Brune of the team's Risk and Quantitative Solutions Group. It is possible investors may see a few additional manager changes and/or adjustments in coming months, but wholesale changes to individual funds' teams or strategies are not on the radar.

In combination, the adjustments above are designed to address the drawbacks of American Funds' multimanager approach. In theory, they should leave IBFA and its siblings better equipped to navigate what's becoming an increasingly challenging environment for fixed income. But while they show some early promise, we'd need to see additional evidence of their success before considering an upgrade from IBFA's Neutral overall rating.

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