That's not a call to sell bond funds but rather to check them out because the wild conditions that the market has lived through since the end of June have created the perfect crucible for stress-testing a bond fund's portfolio and your tolerance for what the fund holds.
Up until June 30, it was a great time to be a hare in the bond market. The hares -- the funds that stretch for extra yield -- were rewarded for taking high risks. In fact, the bond markets were so favorable that most all bond-fund managers had an easy time putting up decent results.
Read about one stinker bond fund. That changed as the subprime mortgage mess gained steam. If you set aside the headlines tormenting fixed-income land, you can sum up the current situation this way: It's a great time to be a tortoise.
The types of investments that the hares used to race ahead -- mortgage-backed securities, some junk bonds and other areas that have been captured in the headline risk of the last two months -- have been hurting. Meanwhile, Treasury yields are down dramatically, and when yields fall, bond prices rise.
The Lehman U.S. Aggregate Bond Index is up 5.6% year to date through early August. Of that move, nearly 1 percentage point occurred in July, a fairly hefty one-month jump for bond funds.
Thus, the tortoises among general bond funds -- the ones that stuck to their knitting without trying to goose yields -- have been able to catch up and, in most cases, take a lead.
"With bond funds, this is a time to take your temperature -- in terms of whether you can handle losses -- and then the temperature of your fund to see if it's been running fast and is now out of breath," says Morningstar bond fund analyst Paul Herbert.
And that's why in this unusual case, it's worth looking at short-term performance and drawing conclusions from it.
"Most people buy bond funds with certain expectations, and if your bond fund is not performing along the lines of its peers and its benchmarks over the last four to six weeks, then there's a very good chance it is investing in some securities that might make you nervous," says Mary Ellen Stanek, portfolio manager for the Baird Aggregate Bond fund
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10.64, -0.03, -0.3%) .
"A fund manager has to do something specific to have performance that deviates substantially from the stated benchmark. If the tracking error in the short run has been substantial, it tells you the fund is probably doing something you didn't expect."
Don't overreact
Even if performance has suffered since June, automatically selling would be an overreaction. Investor nerves right now have more to do with the volatility in the bond market rather than with actual locked-in losses. Instead, recent performance may be a call to look more closely at the fund and how it pursues its strategy.
Bond funds are inherently murkier than their stock cousins; the average investor can't look at a bond portfolio, pick out a few tickers and get a sense of what the fund is doing. Instead, they could find a bunch of unrecognizable names, representing bonds with any number of embedded features that won't show up when included on a laundry list of holdings.
The performance numbers, however, won't lie. And if they paint a picture of a fund that has overreached for yield and underperformed as a result, react appropriately.
That means calling the fund for a current breakdown on holdings and strategy. There's nothing wrong with holding mortgage-backed securities or junk and more, so long as it's what you expected the fund to do; there's something very wrong with being kicked around because your fund owns securities you ordinarily avoid.
Says Jeff Tjornehoj, senior research analyst at Lipper Inc.: "This is one of those rare cases where short-term fluctuations have opened up a curtain and showed investors the ugly side of some funds, the ones that are supposed to be safe and provide steady income. ... If you are concerned about the performance of your bond fund, you owe it to yourself to take a look."
