From the January 2009 issue of Wealth Manager Web • Subscribe!

January 1, 2009

FLEXIBLE AND SRI

With credit markets in disarray, intermediate-term bond funds have slumped. During the first 10 months of 2008, the funds lost 8.4%--a particularly disappointing performance because intermediate funds have a long track record for delivering steady returns. In fact, since Morningstar began keeping records in 1980, there have been only two losing years. Until now, their worst showing occurred in 1994 when these funds lost 4.0 percent.

Focusing on a mix of government and corporate securities, intermediates suffered from a variety of problems in recent months. In the panic that swept the markets, investors dumped corporate bonds of all types and fled to the safety of Treasuries. Prices of investment-grade corporate bonds dropped. And when bond prices fall, yields rise. Currently the yield on investment-grade corporate issues is around 9%, about six percentage points higher than the yield on Treasuries. Last spring the spread was only two and a half percentage points. Spreads on junk bonds, which are rated below-investment grade, surged from six percentage points in the spring to more than 19 percentage points [as we go to press] in December.

Troubles in mortgage markets also punished intermediate funds. Prices of prime and subprime mortgage securities collapsed. Now some AAA-rated mortgage-backed securities yield 15 percentage points more than Treasuries.

Have intermediate funds reached bargain levels? Perhaps. The funds now yield 5.5%, an attractive payout for portfolios that have an average credit quality of AA.

Whether or not bond markets have stabilized, the best intermediate funds can make solid core holdings. Top choices have proved resilient, recording little or no losses during periods when stocks have dropped. And because many intermediate funds hold broad mixes of fixed-income securities, they can provide important diversification for bond portfolios.

Which intermediate-term fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by FI360, a consulting firm in Sewickley, Pa. FI360's due diligence process seeks funds that are at least three years old and have a minimum of $75 million in assets. Three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80% of the fund's holdings must be consistent with the category.

The screens reduced the field from 1,003 down to 138. Top contenders included Janus Flexible Bond, Managers Fremont Bond, Metropolitan West Total Return Bond, and Wells Fargo Advantage Total Return. We awarded the title to Calvert Social Investment Bond which had the best five-year returns of any finalist.

Calvert won the competition by following a flexible style. While many of its peers focus on a narrow group of investment-grade bonds, Calvert portfolio manager Greg Habeeb considers the full range of fixed-income securities. "We look at everything from the least risky governments to the most risky high-yield bonds," says Habeeb.

Habeeb develops views on the outlook for the economy and all the fixed-income sectors. Then he shifts the portfolio, overweighting junk bonds one year and high-grade mortgages the next.

Through much of the 1990s boom, Calvert was underweight corporate bonds. With default risk low, investors bid up bond prices, and Habeeb worried that corporate yields were relatively low considering the risks. Then in 1998, Russia defaulted on debt, and bond markets were roiled when hedge fund Long-Term Capital Management failed. Corporate bond prices fell, but Calvert avoided most of the problems. "We didn't get hit as badly as some other funds because we lightened up our corporate positions and moved into high-grade mortgages," says Habeeb.

Then with corporate bonds selling at depressed levels, Calvert began buying. That enabled the fund to profit when corporates rebounded in 1999. When stocks tumbled in 2000, corporate bonds sank again. Habeeb started buying high-quality corporate bonds. The new purchases helped the fund to ride a rebound in 2001, returning 13.4% for the year, and outdoing 99% of competitors.

With the economy growing and defaults low, corporate bonds rallied in 2005 and 2006. Worried that yields were too skimpy, Habeeb again shifted to mortgages and AAA-rated securities. That caution paid dividends in 2007 when the credit crisis began spreading, and corporate prices softened. For the year, the fund returned 6.7% and outdid 85% of competitors.

When corporate bond prices dropped in 2008, Habeeb began buying high-quality corporates and moving away from AAA-rated bonds. The percentage of assets in AAA-rated securities dropped from 71% in 2007 to 48% in July 2008. Assets in securities rated AA and A climbed from 15% in 2007 to 38% in 2008. If the corporate markets revive, Calvert should enjoy a boost. But even if the markets remain unstable, the fund should prove relatively resilient because it maintains an average credit quality of AA.

As a socially responsible fund, Calvert can only take bonds that meet certain criteria. The fund seeks securities from companies with good environmental records and avoids bonds from suppliers of tobacco and weapons. The criteria don't seem to have hampered the performance of the fund, which has returned 5.1% annually during the past decade, outdoing 94% of competitors. Whether or not an investor prefers socially responsible funds, Calvert makes an intriguing choice. The fund has proven that it can excel in good times--and remain relatively steady in difficult markets.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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