Beware of Big Fund Yields

10/31/2011 9:00 am EST

Focus: FUNDS

There are a lot of ways to measure risk. Some are better or worse than others, but not a single one is perfect. There’s simply no way to know with certainty how an investment is going to act in the future, says Eric Jacobson of Morningstar FundInvestor.

Of all the ways we use to measure bond-fund risk, one in particular is often a bit of a contrary indicator to many investors: yield.

In other words, many people look to purchase funds based on the magnitude of their yields, out of the sometimes misplaced belief that it will presage the portfolio’s future annual return. Of course, when a fund’s price return is factored in—and the risk that it could drop—that promise starts to look a lot more illusory.

A generous yield is in higher demand than ever, but also stands as a crucial indicator of the amount of risk being incurred within portfolios.

Sometimes that risk is borne out in actual pain, and sometimes adept management prevents that from happening. Yet there are a precious few indicators that offer as useful or as close to a real-time snapshot of a fund’s risk-taking.

Take DoubleLine Total Return Bond (BLTX), for example. The fund has been on a tear for almost as long as it’s been around, ever since manager Jeffrey Gundlach founded his new firm and launched the portfolio in early 2010.

It has gained nearly 9% for the year to date through September 30, and has consistently generated the highest annualized yield of its closest competitors in the bond-fund universe since its launch. That figure clocked in at 8.5% on the last day of August 2011.

The magnitude of that number should catch anyone’s eye, though, despite the fund’s massive success. It comes courtesy of a mix of agency and non-agency mortgages, which in July included more than 18% in what one might refer to as exotic mortgage securities, and roughly 28% in non-agency debt originally rated below BBB.

Gundlach has generally done a masterful job assembling those kinds of risks at odds with each other so that they balance out when the market gets dicey, but his methods aren’t foolproof. He himself has noted that a double-dip housing crisis, in particular, would likely take a toll on his strategy.

Meanwhile, the fund fared relatively poorly during the global market sell-off during the third week of September, placing it in the intermediate-term bond category’s bottom quartile for that brief period.

There are plenty of other examples to go around, though, both in the taxable and municipal universes.

Putnam Diversified Income (PDINX) is another big yield generator, having thrown off 8.3% for the past 12 months through August. That fund, too, is driven by a healthy allocation to exotic mortgages, however, in addition to the foreign-bond and high-yield debt risk that it—and most other multi-sector portfolios—assumes.

That fund has also found rough sledding over the past month, not to mention the rest of 2011, during which it has fallen more than 4% and trailed 95% of its category peers.

On the muni side, there are the perennial yield leaders at Oppenheimer Funds, such as Oppenheimer Rochester National Muni (ORNAX) and Rochester Municipals (RMUNX), which boasted payout numbers of 8.1% and 6.7%, respectively, as of August.

Both funds have produced bursts of excellent returns in the past but have also found themselves reeling when the going gets tough, thanks to heavy exposure to mid- and lower-quality bonds. Neither has suffered recently, in part because they boast levels of sensitivity to the Treasury market—which has been rallying hard—beyond those of most competitors.

Regardless of where you look for your next bond portfolio, be sure to look past even the most compelling statistics before you take the plunge.

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