All things being equal, when interest rates fall, the prices of bonds--and thus of bond funds--rise. Such is the math of fixed-income investing. One would think, therefore, that the net asset values of the top bond funds from 20 years ago would now be comfortably higher than when the new millennium arrived.
Not so. Some bond-fund managers strenuously attempt to grow their funds' capital bases, others take the neutral road, and still others permit their NAVs to decline. Each approach has its attractions--for example, funds with eroding NAVs often come with higher yields. However, as there are significant disparities among funds, it behooves investors to understand the details.
This column evaluates the 20-year results for December 1999's 10 largest taxable-bond funds. (Remarkably, all 10 funds still exist today.) The table below depicts the change in principal for each fund over the past two decades, assuming that shareholders chose to receive their income payments but reinvested any capital gains distributions.
High Growth The two high-growth funds offer a cautionary tale. Despite Pimco Total Return's PTTAX excellent performance, which resulted in the fund boosting its capital base by 44% during this century's first two decades, it has suffered the most redemptions of any bond fund in history. At $70 billion, Pimco Total Return has lost more than 75% of its peak assets, which it reached in 2013.
At least Pimco's fund remains larger than it was in 1999. The other big capital-growth winner, Fidelity Advisor High Income Advantage FAHYX, has outright shrunk, plummeting from being the 10th-biggest taxable-bond fund to the 370th today. Such was the fund's reward for expanding its NAV by one third, even as the typical high-yield bond fund dropped 4% of its capital.
Obviously, investors aren't opposed to turning profits. The problem is they expect their bond funds to be predictable and stable, but growing capital requires taking chances. When Pimco Total Return's investment wagers were temporarily unsuccessful, shareholders rapidly headed for the exits. (Their concerns were exacerbated by the firm's internal turmoil.) Meanwhile, the Fidelity fund boosted its NAV by owning a small stake in equities--a sensible tactic for growing principal but, it seems, unnerving for potential investors.
Tellingly, the two bond-fund Morningstar Categories that have most aggressively increased their capital bases, long government and emerging markets, are tiny. In theory, everybody wants bond funds that expand their NAVs. In practice, investor enthusiasm is decidedly muted.
Moderate Growth The two funds that occupy the second quartile each come from Valley Forge, Pennsylvania. The funds also have been relatively popular, with Vanguard Total Bond Market Index VBTIX remaining among the industry's giants, and Vanguard GNMA VFIIX faring well for a mortgage fund (a species that lost popularity after the 2008 financial crisis).
It might seem that the funds benefited from Vanguard's low expense ratios, which preserve more of their capital for shareholders. Not so, because mutual funds (and exchange-traded funds) are required to pay expenses out of their income receipts. Also, while Vanguard's funds have appreciated handsomely by the standards of the industry's giants, they have been only average when compared with the typical fund. Once again, Vanguard opted to hug the middle of the road.
Slight Growth The third group of funds pretty much missed the great bond bull market. With Morgan Stanley Institutional Core Plus Fixed Income MFXAX and American Funds Bond Fund of America ABNDX, the problem was a disastrous 2008, when the two funds were punished for holding too many weaker credits and lost about 20% of their principal (Morgan Stanley somewhat more, American Funds somewhat less). In contrast, Vanguard Short-Term Investment-Grade VFSUX could never have been expected to grow capital, given its holdings' limited durations.
Besides getting clocked in 2008 and investing solely in short-maturity notes, bond funds occupy this group by owning premium-priced issues. Such funds tend to have pleasant current yields and perform well enough when interest rates rise, but when interest rates decline, their holdings sometimes disappear. Higher-yielding mortgage-backed securities vanish when mortgage holders refinance, while corporate bonds may be called by their issuers. (The danger from calls is even greater for municipal bonds.)
Capital Loss The final three funds have shed principal. Invesco Global Strategic Income OSIIX is an old-school bond fund, which is not a compliment, as it refers to a relatively high-cost offering (annual expenses of 0.62% for the institutional share class, which requires a $1 million investment even to achieve that price) that follows an investment strategy that has been too complex for the fund's own good.
Franklin U.S. Government Securities FUSAX has followed an extreme version of the premium-bond strategy, possessing high-income government mortgages that mature very quickly, because those mortgage holders quickly refinance. Note the disparity between Franklin's total and that of Vanguard GNMA, which nominally invests in identical fashion! A rose may be a rose may be a rose, but one government-mortgage fund is not necessarily like another.
As for Vanguard High-Yield Corporate VWEHX, its outcome resembles that of most high-yield bond funds, which have given up with defaults and/or credit downgrades what they have gained from interest-rate decreases. Expect such funds to show even steeper NAV erosion in the future, when they are unlikely to be cushioned by further rate declines. Distributing all the income from junk bonds, while taking hits to capital from credit problems, is a sure way to shed principal over time.
Conclusion Over the past 20 years, the rising tide lifted most bond-fund boats, while limiting the losses for those funds that did endure principal losses. The next two decades will almost certainly be less kind. In such a climate, understanding a bond fund's potential for capital growth (or, more realistically, preservation) would seem to be even more important than in the past.
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.