4 Bond-Fund Basics Worth Knowing

Your Benchmark is Worthless Well, maybe not if you're talking about niches like Ginnie Mae or Treasury funds, but when it comes to your core bond portfolio, the Bloomberg Barclays (née Lehman Brothers) U.S. Aggregate Bond Index just isn't going to do you much good.

True, correlations between the index and the intermediate-term bond Morningstar Category have come back to high levels since the global financial crisis. Still, the index became a lot more homogenous after the crisis and many fund managers have gone the other way, with the largest (and often best-performing) funds in the group investing heavily outside of the index.

Out-of-benchmark positions that might have included just a smattering of high-yield bonds, now often include sectors that run the gamut from high-quality securitized fare (such as commercial mortgage-backed securities or collateralized loan obligations), to non-dollar developed-markets bonds, to emerging-markets debt. That makes the index much less useful both as a measuring stick for risk and a benchmark for performance.

The most dramatic divergence between the index and the intermediate-term bond category happened during and immediately after the financial crisis. However, the two have been dancing back and forth—albeit on a lesser scale—in recent years as well. As many funds in the group have maintained less rate-sensitivity in anticipation of rising bond yields, the index has fallen behind during rate sell-offs. By contrast, in periods in which credit-sensitive sectors have suffered, the category has mostly trailed the benchmark. That’s not all bad given the homogeneity of the index and better diversification of most funds, but it clearly makes comparisons less useful.

Your Manager Knows It Of course, this all makes beating your benchmark a whole lot easier. If you've got a market-standard index chock-full of low-return government bonds and you've got the freedom to buy other things that will help you beat it, why rock the boat? Every bond manager knows it's a heck of a lot easier (at least before fees and in a bull market...) to beat the U.S. Aggregate than it is for the stock jocks down the hall to outgun the S&P 500.

If your manager is using the Aggregate, it doesn't mean he or she is lying or trying to put one over on you; rather, chances are that they’re caught in a wave of inertia. The "Agg" has been the industry's lodestar for years and years, and it acts as the starting point for most discussions about the taxable-bond market. The marketers at their firms, meanwhile, would not look kindly on pioneering a move to a more well-suited but tougher-to-beat index, either.

In a perfect world, your bogy would have exposure to every market in which you might choose to invest and be weighted in the way a reasonable manager might view as neutral. Most indexes are weighted by outstanding issuance, though, and Uncle Sam is far and away the biggest borrower on the block. Even before he took over Fannie Mae and Freddie Mac, the Aggregate had only modest weightings in the nongovernment sectors that managers could use to diversify.

Other sectors are also lightly weighted in the Agg because they can be difficult to track or price. The index has strict inclusion criteria that are popular among those who want its indexes to represent the most-liquid parts of the market. That also means the 26% corporate-bond weighting in the Aggregate represents only 59% of the U.S. corporate-bond debt outstanding, according to industry trade group Sifma. The $98 billion or so of asset-backed securities in the index? That's about 7% of the total out in the marketplace.

Risk is Back After the financial crisis, it became conventional wisdom that runaway rising interest rates would be right around the corner. That was roughly eight years ago, and notwithstanding a few nasty spikes, rates have mostly ground lower and lower. In mid-October the yield on the 10 Year Treasury Note clocked in at only 2.3%. That's low enough that a big enough inflation scare could do a lot of price damage. As investors have looked elsewhere for yield, meanwhile, they've driven them down across credit markets. Some parts of the high-yield market looked mouthwateringly cheap in early 2016, but it has rallied incredibly since then. Now, junk bond yields and their spreads over Treasuries are both back down near historical lows, and we're eight years since the last recession. With income that thin there's little room for error in the event that a slowdown leads to an uptick in defaults.

Fees Are Important--No, Seriously By now that probably sounds like a broken record, especially to the "You get what you pay for" and "Premium performance deserves premium pay" crowds. Here's a quick snapshot of why they're wrong. Reason one is simple, especially in the comparatively modest-return world of bonds. Every dollar you pay in fees is a dollar you don't get in returns, and at today's yields the same expense ratio eats up more of your income than it used to. And while truly great managers may deserve something extra for what they bring to the table, the margin of their greatness, and the extra dollars that it deserves, have been greatly exaggerated. Meanwhile, the only way to consistently beat high fees is to take on more risk.

Here's another way to look at it: Good bond-fund performance plus high expenses almost surely means that your bond portfolio is taking on more risk than you need to.