4 Core Bond Funds That Are Better Than They Look

My colleague Miriam Sjoblom recently warned investors that they may be underestimating, or at least misunderstanding, the potential risks in their bond portfolios if they're assessing risk primarily using volatility-based metrics. The reason: These trailing measures are very time-period specific.

"Historical volatility is also only as helpful as the time period you choose and the specific events that occurred in it--which may not be similar to the risky events to come," Sjoblom said.

Volatility has been scarce lately, she said. To illustrate, let's look at the high-yield bond Morningstar Category over two consecutive five-year periods—one beginning July 1, 2007 and ended June 30, 2012, and the other beginning July 1, 2012 and ended June 30, 2017. The high-yield category's annualized returns were very similar during these two stretches—at 5.5% and 5.6%, respectively. But the path they took to get there was markedly different: The category's standard deviation of returns during the first five-year period was 12.7, whereas the more recent period's standard deviation was only 4.8.

The Sharpe ratio, one measure of risk-adjusted return, looks at the excess return earned by a specific asset (i.e. how much it returns over and above what you could get from a riskless asset like a short-term Treasury) then divides that excess return by the asset's volatility as measured by standard deviation during the period. The goal of this exercise is to determine whether investors were sufficiently compensated for asset's risk (as measured by volatility) during the period. Because the high-yield category's standard deviation was so much higher during the 2007-2012 period, its Sharpe ratio during that period was only 0.42; it was a much better-looking 1.15 during the more recent trailing five-year period.

You can see how a bond fund with a large stake in lower-credit-quality bonds might look pretty solid on a risk-adjusted returns basis over the recent trailing five-year period compared with its higher-quality peers. But what if we see higher volatility during the next five years? Bond investors would do well to pay attention to potential risks that trailing volatility measures may not be highlighting--credit quality (or other fundamental measures of default risk), duration, and currency exposure, for example.

"Bond managers who have been willing to underperform lately, both in absolute and risk-adjusted terms, rather than follow the crowd into riskier territory, may be set up to succeed in the future," Sjoblom said.

With that as a springboard, I searched for some highly rated core bond funds that have underperformed lately owing to their conservative positioning, but which have strong fundamentals and disciplined approaches that would likely help them hold up well in a risk-off environment.

Relative to competitors in the intermediate-term bond Morningstar Category, Silver-rated Fidelity Intermediate Term Bond has a restrained risk profile. For starters, it tends to court less interest-rate risk; duration is currently 4 years compared with 5 years for typical fund in the category, said analyst Emory Zink. The fund tends to favor corporates, and though the portfolio includes a sizable stake in BBB rated bonds (22%), it limits its exposure to below-investment-grade to 5% and currently holds even less than that. When compared with peers that have a similarly short duration, the fund's returns are solid, and its relatively high 12-month yield combined with a low expense ratio gives the fund a boost in a universe where every basis point counts, Zink said.

For investors in search of a more conservative intermediate-bond fund, this one deserves a look. Silver-rated Wells Fargo Core Bond doesn't make big interest-rate bets, keeping its duration and yield curve positioning in line with the Bloomberg Barclays U.S. Aggregate Bond Index. Furthermore, it invests only up to 5% in high yield, and it cannot invest in nondollar bonds or in futures, putting it on the more conservative side of the intermediate-term bond spectrum, explains senior analyst Maciej Kowara. There are markets where this fund will not shine: Its duration-neutral stance makes it vulnerable in rising-rate environments, and its low absolute and relative exposure to lower-credit-quality bonds will cause it to lag during high yield rallies. But for investors whose horizon is at least as long as the whole market cycle, Kowara believes the fund is one of the better options out there.

Though the team running Silver-rated JPMorgan Core Bond tends to keep its duration neutral to the Bloomberg Barclays U.S. Aggregate Bond Index, its portfolio differs markedly from the index and peers in the intermediate-term bond category. The fund typically allocates more to mortgages than its peers (40%-65%), while 15%-35% of the portfolio is typically devoted to investment-grade corporate and asset-backed securities, and 15%-33% to Treasuries. The fund avoids junk-rated debt and focuses on bonds the team expects to hold until maturity. This results in a generally high-quality portfolio with low turnover. Compared with peers who are not as focused on mortgages and aren't as conservative with credit risk, the fund has lagged lately. However, the fund's consistent and defensive return profile led our manager research team to award it a Positive Performance rating.

This Gold-rated fund's more conservative profile has resulted in decent, though not stellar, returns compared with peer funds during the past few years, says associate director of fixed-income strategies Karin Anderson. Though the current portfolio's duration is slightly short of the benchmark and it devotes less than 5% to below-investment-grade securities, prospective investors should be aware that the managers have a wide latitude to adjust the fund's duration and credit exposure. Duration can run anywhere from 2 to 8 years, and the fund can hold up to 20% of assets in below-investment-grade securities. But the managers dial risk up and down in predictable fashion based on their disciplined approach to valuations, and over the long term, the team's eye for value and well-timed moves into credit have paid off handsomely, Anderson said.