Overview: Use fixed income to reduce risk, not chase return. Investing in funds that stick to the highest quality of fixed income investments and not making active bets is the best way to reduce risk.

Our philosophy is that the main role of fixed income in a portfolio is to reduce overall portfolio risk to a level that does not exceed the investor’s ability, willingness or need to take risk. With that in mind, we believe that fixed income assets should be limited only to those of the highest investment grades.

 

Thus, we recommend avoiding high-yield bonds and convertible bonds, because they are hybrid securities that contain equity-like risks. We also believe that mortgage-backed securities should generally be avoided because of prepayment and extension risks.

 

Further, we believe that the bond portfolio, like the equity portfolio, should be passively managed. By seeking alpha and investing in actively managed funds, investors could significantly underperform benchmarks. Those risks showed up for investors in several funds in 2008. For comparison, the Barclays Capital Aggregate Bond Index returned 5.2 percent in 2008.

 

The Helios funds are managed by Hyperion Brookfield Asset Management, and they run three open-end mutual funds. The 2008 total returns for these funds are below:

 

Helios Fund Family
Fund	Return
Helios Select Intermediate Bond Fund (HSIBX)	–84.6%
Helios Select Short Term Bond Fund (MSBIX)	–69.3%
Helios Select High Income Fund (HIFIX)	–76.1%

 

These three funds all lost by investing in subprime debt and debt from financial issuers. The returns of these funds clearly illustrate the risk of investing in an active bond fund. When you’ve bet on the wrong manager and the other investors in the fund exit en masse, you can see bond funds lose more than half of their value in a single year. For a basis for comparison, not even volatile equity indexes like the MSCI EAFE Small Cap Index or the Russell 2000 Value Index lost half their value in a disastrous 2008.

 

The risk of investing in active bond funds is not necessarily shown by huge losses as shown in the Helios funds. Fixed income funds should do well when the rest of the economy is down. In April of 2008, Kiplinger’s Personal Finance named Dodge & Cox Income Fund (DODIX) as a “safe” taxable bond fund.¹ The fund lost 0.3 percent in 2008. The fund cited an overweighting to corporate bonds and to the longer maturities of its bonds as reasons for its underperformance. They admitted they “underestimated the worsening credit crisis.”² The purpose of this example is not to deride the managers at Dodge & Cox for not predicting the depth of the credit crisis, but to deride the hubris of managers who think they can predict the movements of the bond markets with any accuracy or consistency.

While not as dramatic as the losses shown in the Helios funds, the financial press did deem the fund as a safe place to invest fixed income assets. Even the experts cannot predict which active funds will have positive returns.

 

Morningstar named the managers of the Metropolitan West Total Return Bond Fund (MWTIX) as Fixed Income Managers of the Year in 2005.³ The fund lost 1.3 percent in 2008. Three of the four managers of the year remain as managers of the fund in 2009. Either they have lost intelligence since 2005, or the performance they achieved prior to 2005 was simply random luck.

 

The lesson here is that the winning strategy is to use fixed income to reduce risk, not to chase return. Investing in funds that stick to the highest quality of fixed income investments and don’t make active bets is the best way to reduce risk.