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These Funds Deliver Income, but Mind the Downside

Recent market tumult illustrates the risks of several noncore bond-fund types.

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Investors in U.S. and foreign stocks had a difficult third quarter, with stocks posting their worst losses in four years. 

Bonds generally held their ground, and a handful of categories even rallied. As the yield on 10-year Treasuries dropped from 2.4% in early July to less than 2% by the end of September, long-term government-bond funds gained 5.4% during the quarter. The Barclays U.S. Aggregate Bond Index picked up 1.2% during the period. 

Yet, certain fixed-income categories, just like equities, fell on investors' broader concerns about global economic malaise. While their losses were generally smaller than stocks' losses in the past three months, their performance pattern was directionally similar. Not surprisingly, many funds in the high-yield bond, multisector-bond, and emerging-markets bond Morningstar Categories adhered to this pattern. 

Of course, investors may still make room for such offerings in their portfolios: Their yields are higher than higher-quality bond funds, and their returns, in many cases, have also been higher over longer time frames. Given the equity-market rally that has prevailed since early 2009, bond funds taking credit risk have been handsomely rewarded. 

But the recent equity-market shock illustrates that credit-sensitive bond funds are best used as supplemental holdings; they're not going to provide the same ballast that high-quality bonds will when stocks sell off. 

I used  Morningstar's Premium Fund Screener to help illuminate some otherwise-solid funds that have gotten rocked in the recent sell-off. I searched for medalist fixed-income funds, regardless of category, with trailing 12-month yields that were greater than 4%--tantalizingly high by today's standards. (The Aggregate Index currently yields about half that much.) To help identify funds that have fallen more than their peers in down markets, I searched for those with Morningstar Risk ratings of above average or high, as well as three-month losses through Oct. 5, 2015, of 5% or more. Although many of these funds have rebounded in recent weeks as equities have recovered, those losses illustrate the potential for higher-yielding funds to give up their yield advantages in a hurry in inhospitable markets. 

Premium Members can click  here to view the complete screen or adjust it to suit their specifications. As of Oct. 5, seven funds made the screen. Here's a closer to look at three of these funds. 

 Franklin High Income (FHAIX)
Category: High-Yield Bond | Analyst Rating:
This fund lost nearly 9% in the third quarter of 2015. Thus, despite its tantalizing yield of nearly 7%, the fund is well into the red for the year to date. This fund's managers have historically maintained a higher weighting in below-investment-grade bonds than its average peer; it currently has higher weightings in B and CCC rated credits than is the norm in the high-yield category. Positions in energy and basic-materials bonds have also impeded results. But management has maneuvered more adroitly in past high-yield downturns: In 2008, for example, emphasizing defensive utility bonds helped limit losses, though the fund still shed 23% of its value that year. The fund garners a positive Analyst Rating in large part because of its seasoned management team and deep analytical resources, but its low-quality portfolio means it is best used as an aggressive kicker for a fixed-income portfolio. 

 PIMCO Emerging Local Bond (PELAX)
Category: Emerging-Markets Bond | Analyst Rating:
Emerging markets have been at the epicenter of the recent market weakness, so it should come as no surprise that funds that emphasize those markets have fared especially poorly of late. This fund has struggled even more than its category peers, shedding 14% for the year to date through early October, even as it has made up ground in recent days. Given that many of its peers focus on emerging-markets bonds denominated in U.S. dollars, its emphasis on local-currency-denominated debt has hurt it within the emerging-markets bond category; it has also contributed to high volatility relative to the broad peer group. But the fund has struggled alongside other local-currency-denominated emerging-markets funds, too, says senior analyst Karin Anderson. While the fund maintains a Bronze rating, it's best used in small doses and as a diversifier rather than as a component of a traditional bond portfolio. 

 Templeton Global Total Return (TGTRX)
Category: World Bond | Analyst Rating:
Like the aforementioned PIMCO fund, this fund and sibling  Templeton Global Bond (TPINX) are outliers in their category. Whereas many rival funds maintain an emphasis on developed-markets debt, manager Michael Hasenstab has consistently emphasized emerging-markets bonds and currencies, considering these countries' fiscal prospects better than nations in developed markets. That bold positioning hurt during the third quarter of 2015; the fund's 7% loss was far worse than the 1.2% drop of its typical peer. Yet, Hasenstab's thesis has prevailed over longer trailing periods, as both this fund and its sibling have delivered peer-beating results, albeit with higher volatility.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.