The number of bond funds that own stocks has surged to its highest point in at least 18 years and could expose investors to unexpected losses

May 1, 2013, 8:09 p.m. ET

Bond Funds Running Low on…Bonds



The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns. Regulators generally allow funds to hold a mix of assets, but the scale of bond funds’ shift into stocks is unusual, fund experts said, and could expose investors to unexpected losses.

In all, 352 mutual funds that are classified by Morningstar Inc.MORN -0.27% as bond funds held stocks as of their last reporting date, up from 312 at the end of 2012 and 283 in the first quarter of 2012, according to the investment-research firm.

The rush into stocks illustrates the dilemma bond investors face. The bond market has rallied for much of the last 30 years, and yields, which move in the opposite direction of prices, stand near record lows.

When bond-fund managers buy stocks, “They’re reaching for yield,” in the form of dividends, said Russ Wermers, a finance professor at the University of Maryland who studies mutual funds.


The $21 million Forward Income Builder fund, run by Forward Management LLC in San Francisco, had almost no money in stocks at the middle of last year, according to Morningstar. As of the end of February, it had nearly 49% invested in stocks.

Forward has disclosed the increases to fund holders as part of its investment commentaries.

So far the strategy has paid off. The fund through Tuesday has had a total return of 5.8%, including dividends and bond payments, according to Morningstar. That puts it in the top 4% of multisector bond funds, defined by Morningstar as funds that can invest across fixed-income categories like Treasurys or corporate bonds.

“We believe that traditional fixed income is at a historic level of being overvalued,” said Forward Management director of investments Nathan Rowader. In the past few months of falling yields, he said, high bond prices “became an emergency. It’s a dangerous environment for a lot of bonds.”

The yield of the 10-year Treasury is now 1.64%. Federal Reserve officials on Wednesday said that they would continue the huge bond-buying program that’s driven down bond yields and could increase or decrease purchases depending on economic conditions.

Bond and income funds have broad leeway to invest in other securities. The Securities and Exchange Commission generally requires funds to invest at least 80% of their assets in the type of assets suggested by their names. But certain words with vague meanings, like “value” or “income,” don’t trigger the requirement. Funds must also stick to any requirements the managers outline in the prospectus.

As a result, investors in some bond funds could be surprised by large stock exposure. Almost all of the 352 funds investing in stocks call themselves income or bond funds.

Most bond funds’ stock allocations are small, amounting to just a few percentage points of their overall portfolio.

Some funds, however, are piling into equities. The $15.4-billion Loomis Sayles Strategic Income fund has ratcheted up its stock and preferred-stock allocation to more than 19%, from 5% in mid-2011. Co-portfolio manager Matt Eagan said that the fund’s managers decided most bonds were so overpriced that it was worth taking on some stock risk to avoid pain in bonds.

“We’re in the first cycle of a rising rate environment. You really have to start thinking about how your portfolio is positioned and your vulnerability,” he said. The fund’s prospectus allows it to put up to 35% of its portfolio in stocks.

Some financial advisers aren’t fans of the trend. Accredited Investors Inc., an Edina, Minn., registered investment adviser with $1.2 billion under management, last year cut its allocation to the Loomis Sayles Bond Fund by a third after finding out that the fund had started to buy stocks, said Accredited investment manager Jacob Wolkowitz. As of the latest portfolio disclosure, the fund had about 6% of its assets in stocks and preferred stocks.

“We’re completely sympathetic to arguments regarding yield and rising interest rates, but you can’t be making decisions by yield alone,” said Mr. Wolkowitz. He said he is concerned that the stock allocation will make the bond fund more volatile and move more in tandem with stock indexes.

Loomis Sayles’ Mr. Eagan said he thinks most investors in the fund are willing to accept some volatility from stocks in exchange for a higher yield and that the fund is focused on dividend payers that are less volatile than the overall market.

Another wrinkle: Of the 325 funds that Morningstar says specify a “prospectus benchmark” against which they say they should be judged, 313 funds compare themselves against a bond-only benchmark. The prospectus for the Pacific Advisors Government Securities fund, for example, which held 16% of its portfolio in stocks at the end of last year, compares the fund with the Barclays Capital Intermediate Treasury-Bond Index, which includes no stocks.

But high stock exposures can cause trouble. In March 2008, the Pacific Advisors Government Securities fund had 9.8% in stocks. It suffered a 2.3% loss that year, even as other short-term government bond funds surged 5%, Morningstar says.

The fund has used stocks as part of its strategy since inception and makes that clear to investors, Pacific Advisors Funds President George Henning said.

Mr. Henning said the fund invests in low-volatility stocks and that he thinks investors should be more wary of how rising interest rates would hit bonds than of stock market instability.

“To me, it’s a question of how you want to manage risk,” he said. “We think this is a good way to do it.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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