Are There Stocks in Your Bond Portfolio?

Some bond fund investors received an unpleasant surprise in the fourth quarter of 2018, when stock market losses stung their bond portfolios.

For the most part, meaningful equity stakes in bond funds are rare. Most bond fund managers stick to bonds, or hold only tiny positions in common stock that might come from a bankruptcy restructuring, or from the conversion to equity of a convertible bond. Of the 280-plus taxable-bond funds that we rate, about one in 10 held more than a couple of percentage points in stocks as of its most recent portfolio, and only a handful held more than a five-percentage-point stake.

But some funds do make more ample use of stocks. These can help boost returns during healthy markets, but can also trigger painful losses when equity markets falter, as they did last fall. Of the funds we rate with significant stakes in equities, most fall in the multisector or high-yield bond Morningstar Categories. Encouragingly, many (but not all) managers had trimmed larger positions prior to the recent sell-off.

Fidelity Capital & Income FAGIX Manager Mark Notkin runs one of the most-aggressive portfolios in the high-yield bond category. He has at times held large stakes in the lowest-rated tiers of the junk-bond market, and will also hold common stock. As junk bonds recovered from the depth of the credit crisis, Notkin dialed down risk in the fund's high-yield stake but added to equities. As of October 2018, the fund held close to 21% in stock, including more-aggressive names such as Alibaba BABA and Alphabet GOOGL. The fund's adventurous streak has helped propel it to one of the best returns in its category over the trailing 15-year period—but also made it one of the category's most volatile over that period. It suffered a particularly steep 8% drawdown in the fourth quarter, one of the worst showings in the high-yield category. Sibling Fidelity Advisor High Income Advantage FAHYX, run by a Fidelity colleague with a similarly equity-heavy approach, fell even further with an 8.3% loss.

T. Rowe Price Spectrum Income RPSIX This fund of funds holds a strategic allocation to equities via its investment in T. Rowe Price Equity Income PRFDX, with total exposure standing at a little less than 10% as of September 2018. The latter offering's 12.3% loss during the late 2018 sell-off contributed to T. Rowe Price Spectrum Income's roughly 1.5% fall over the period. That said, it was one of the few bond funds with relatively large positions in common stock that held up relatively well, only modestly lagging the multisector category's median loss. Relatively high-quality bond positions elsewhere in the portfolio appear to have provided valuable ballast.

Lord Abbett Bond-Debenture LBNDX This portfolio ranks as one of the more-aggressive options in the multisector category, investing across a mix of junk bonds, bank loans, emerging-markets debt, and equities. That combination has helped earn the fund a topnotch record under its current team. The fund came into 2018 with a 15% allocation to stocks, a position that stood at a slightly lower 9.3% by year's end. The fund's near-5% loss in the fourth quarter of 2018 lagged the vast majority of its multisector peers.

Loomis Sayles Strategic Income NEFZX Comanagers Dan Fuss, Elaine Stokes, and Matt Eagan found good value in stocks in recent years, especially since 2011 as they soured on bond valuations. With a focus on dividend-paying blue-chip names, the team allowed this stake to grow to more than 20% by late 2013, helping to power returns when equity markets were strong. By late 2015, the team started to cut the position, which stood at 5% as of November 2018, a stake dominated by Bristol-Myers Squibb BMY. That stock lost 15.6% between October and December, though, and the fund's 4.5% loss over the period trailed most of its multisector bond peers'. A large allocation to high yield also likely hurt performance.