In 2022 and the first three quarters of 2023, investors learned anew the negative impact of rising yields on bond prices, but lately, the market has taught the opposite lesson. After the yield on the 10-year Treasury topped 5% intraday on Oct. 23, yields have fallen across all maturities, including the 10-year to around 4% in late January 2024, and now most members of the Federal Open Market Committee project lower short-term interest rates, which would likely mean falling yields for longer maturities, as well.
Whereas rising yields hurt bond prices, falling yields help them. A $100 bond with a 5% coupon and 10 years to maturity would increase in price to $108.11 with a 100-basis-point fall in yield, for example. Investors should thus look for managers who aren’t just chasing bonds with the highest yields and less regard for risk, but who are also looking for price appreciation. That could come from a further drop in yields, especially for bonds with longer durations (a measure of interest-rate sensitivity) or with ratings upgrades for corporate issues.
The four funds highlighted below all receive High People, Process, and Parent ratings because their managers do a good job balancing the potential risks and rewards of bond investing, whatever path yields take in the next few years.
American Funds Bond Fund of America BFAFX, which receives a Morningstar Medalist Rating of Silver, has benefited from parent firm Capital Group’s multiple investments in its fixed-income platform over the past decade, including the hiring of Pramod Atluri away from a competitor in 2016.
Atluri has led this fund’s four-person management team since 2020. Atluri and his comanagers will buy high-yield credits they expect to be upgraded to investment grade, but they keep the fund’s junk-bond exposure below 5% of assets, in line with the intermediate core bond Morningstar Category norm. They will also take modest interest-rate risk versus the Bloomberg U.S. Aggregate Bond Index by deviating up to a year in duration, but in practice, they have rarely diverged by more than half a year.
Fellow core strategy Baird Aggregate Bond BAGIX and its intermediate core-plus bond sibling Baird Core Plus Bond BCOSX are more conservative still in their approach to interest-rate bets. The managers match each fund’s duration to its respective index, the Bloomberg U.S. Aggregate Bond and Bloomberg U.S. Universal, though the strategies will differ in bets across maturities. Junk-bond exposure for both strategies is modest, too, relative to most peers. The strategies instead try to distinguish themselves through simplicity: They don’t use derivatives and keep fees low enough that no heroics are required. Security selection and sector rotation have helped each to competitive results.
Dodge & Cox Income DODIX is the most aggressive of the four options, but its veteran management team has shown good judgment in taking risks. Investing with a three- to five-year horizon, the team will deviate from the benchmark’s duration by more than a year and aims to build a portfolio that outyields the index, which has often meant overweighting corporates and agency mortgages, and at times a 10%-plus stake in high-yield debt.
The portfolio’s corporate allocation is where much of its risk resides; the managers often concentrate exposure in around 50 issuers and will take contrarian positions, such as buying Wells Fargo debt in 2016 and Charles Schwab bonds in 2023, when both faced business challenges.
Investors can expect this strategy to lag in credit selloffs, as in early 2020, but the managers tend to find bargains in dicey markets, and the strategy rebounds well. Long-term performance has been excellent.
This article first appeared in the January 2024 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.