Calvert News & Commentary

Understanding the Bottom Line of Bond Funds

Looking at only yield can result in some unexpected challenges

7/26/2010

Interest rates continue to hover at historical lows, making it tempting to invest in bond funds that offer higher yields. But will higher-yielding funds really deliver the best potential overall performance? Looking only at yield ignores other critical components of fixed-income investing—and the fund’s overall total return.

With market interest rates currently poised to move higher, it is now more important than ever to consider factors other than yield when evaluating a fixed-income fund. With the Federal Reserve’s (the Fed) benchmark lending rate close to 0%, many analysts believe that it is only a matter of time before the Fed starts to raise interest rates. In addition, the U.S. Treasury has been issuing record amounts of new debt to finance the huge government stimulus programs enacted in response to the financial crisis of 2008 and 2009. Eventually the outstanding supply of Treasuries may begin to outstrip demand, causing Treasury yields to rise.

In this transitional and volatile bond market, let’s take a closer look at the different factors that affect overall bond fund performance. Calvert’s fixed-income investment team applies a comprehensive, relative-value approach to identify attractive investment opportunities in a shifting bond market environment.

Chasing Yield

Some bond fund managers strive primarily for higher yields, either explicitly in the case of high-yield bond funds or less obviously in terms of a manager’s overall style and process. But investors should ask themselves just what these funds hold that allows them to achieve higher yields.

Higher yield typically implies higher risk. So while you may think you are getting a conservative or moderately risky bond fund, a fund in search of yield could be investing primarily in riskier bonds, such as certain types of structured mortgage-backed products or longer-maturity bonds, which can increase a fund’s sensitivity to interest-rate risk and make it more volatile.

Calvert’s flexible, active management approach includes duration¹ and yield curve considerations. The management team seeks relative-value opportunities across the various fixed-income market sectors, including corporate bonds, Treasuries, and asset-backed securities. Extensive credit analysis of all potential investments helps identify bonds with attractive price appreciation potential.

Calvert’s Total Return Approach

Calvert manages its taxable fixed-income funds for total return, which is the combination of yield and the price appreciation (or depreciation) of the bonds in the fund. Calvert’s portfolio managers aim to consider all of the factors that can contribute to a bond fund’s value, including sector allocation, credit quality, yield, and interest rate considerations.

Comprehensive, integrated process. Our approach to duration reflects a continuous sensitivity to the interest-rate environment. This allows us to make adjustments to the duration of a fund to reflect short-term movements in rates while also factoring in long-term forecasts. We closely monitor and manage our Treasury and Treasury futures contract positions in order to take advantage of anticipated changes in the shape of the Treasury yield curve.

Flexible sector management. Calvert does not confine its approach to sector selection only to the sectors in a fund’s benchmark. We look for opportunities in sectors that offer value based on current valuation relative to historical averages or our economic outlook, regardless of whether or not a sector is in the benchmark. Our strategy is to move out of sectors that no longer offer significant upside potential and into sectors that appear to be undervalued.

Active security selection. Calvert’s taxable fixed income portfolio management team applies an active trading strategy that reflects a willingness to sell or reduce its exposure to a holding based on the identification of another security that they believe offers better relative value.

The Bottom Line

Before you invest in a bond fund, make sure that you understand how the fund is managed. Look at whether it is actively managed based on the portfolio manager’s beliefs or is managed more to follow its benchmark. Examine factors that the manager considers when selecting investments.

With interest rates poised to eventually move higher, it may make even more sense now to focus on bond funds that take a well-rounded approach to portfolio management instead of maximizing yield. This is because (all else being equal) rising interest rates typically hurt the value of longer-duration, higher-yielding bonds more than shorter-duration, more conservative holdings.

Calvert’s taxable bond funds may offer an attractive combination of income and total-return potential as a result of our portfolio managers’ comprehensive and integrated fixed-income investment process. This integrated approach, which focuses on holding the bonds that offer the most relative value, has proven to be effective in periods of both rising and falling interest rates. In the current, transitional bond market environment—as we anticipate an increase in short-term interest rates by the Fed—Calvert’s bond funds may offer attractive potential for both income and total return.

1. Duration measures a portfolio’s sensitivity to changes in interest rates. Generally, the longer the duration, the greater the change in price in response to a given change in interest rates.

Investment in mutual funds involves risk, including possible loss of principal invested. Bond funds are subject to issuer default risk and interest rate risk, the risk that changes in interest rates will adversely affect the value of an investor’s securities. When interest rates rise, the value of fixed-income securities will generally fall. The value of a futures contract tends to move in tandem with the value of the underlying instrument, can be highly volatile, and the potential loss from futures can exceed a bond fund’s initial investment in such contracts. High-yield bonds involve a greater risk of default and price volatility than U.S. Government and other high-quality bonds. High-yield/high-risk bonds can experience sudden and sharp price swings, which will affect net asset value.