Is your bond fund dabbling in stocks?

 David Peartree, The Daily Record Newswire

Over the past year, as it became evident that the 30-year bull market in bonds was over, the challenges facing bond investors have been thoroughly dissected and catalogued. One risk that has been largely overlooked is that some bond funds are not what investors think they are.

Rising interest rates are a primary risk to bond prices, and that’s where most attention has been focused over the past year. Interest rates and bond prices have a teeter-totter like relationship: as one goes up, the other goes down. For most of the bond market, that was the story for 2013.

Interest rates rose and bond prices dropped. The 10-year Treasury yield, a benchmark yield for much of the bond market, went from 1.86 percent to 3.04 percent. Most sectors of the bond market, other than short-term U.S Treasuries and high yield bonds, finished the year with negative total returns.

Another much discussed risk to bonds is inflation. Inflation is a risk because it eats away at the value of any fixed income asset. So far, however, inflation has remained subdued if not below a level the Federal Reserve would like to see as one signal of robust economic growth.

Rising interest rates and inflation will continue to represent the major risks to bond investors over the coming years, but there are other risks. One risk that has been flying under the radar of most investors is the increase in stock ownership by many bond funds. How do bond funds come to own stocks and should investors be concerned?

Even with the rise in rates, bond yields are still low by historical standards. Individual investors have been accused at times of “reaching for yield.” It turns out that some bond managers have been doing the same. Frustrated by the low return prospects offered by the bond market, some bond managers have decided to venture into stocks in search of higher dividend yields and better total returns.

The SEC requires a mutual fund to invest at least 80 percent of its assets in the type of asset suggested by the name of the fund. This is basic truth in advertising regulation.

A “bond” fund should invest in bonds, but the regulations permit up to 20 percent to be invested in other types of securities including stocks, commodities or real estate. It’s up to the investor to figure this out by reading the fund prospectus or actually reviewing the fund’s holding list.

A search through the Morningstar fund database identifies several hundred “fixed income” funds that own stocks. Many of these funds hold less than one percent of their allocation in stocks, but some have more significant stock allocations. Dozens of funds hold between five percent and 20 percent in stocks.

These funds typically describe themselves as “bond” or “income” funds. A “strategic income” fund might be open to interpretation, but few would suspect that a self-described “bond” fund holds stocks.

Investors can never assume. In one particularly striking case, a short-term government bond fund reported stock holdings in excess of 17 percent. In another, an intermediate-term bond fund reported stock holdings in excess of 18 percent.

These funds are not violating the law. They are disclosing what they are doing in their prospectus, annual reports and holding reports. The question is whether investors are paying attention.

For investors, this practice presents several problems.

First, investors may be taking on more risk than they expected. Stability and income are two of the most fundamental reasons for owing bonds. Stocks may offer an alternate source of income but not stability. Even dividend paying stocks should not be viewed as a source of portfolio stability.

Second, it becomes harder to accurately assess performance. Most of these funds identify a bond-only benchmark in their prospectus, but a comparison with an all-bond benchmark become less meaningful, and perhaps misleading, as the allocation to stocks drifts higher.

Third, if the fund manager is able to drift between bonds and stocks, the investor relinquishes some control over the all important asset allocation decision. Studies have repeatedly shown that deciding how to allocate investments across asset classes like stocks and bond and their respective sub-classes is the most significant driver of investment returns.

For some investors, that is the point: Let the manager decide.  But for the investor wishing to maintain tighter control over asset allocation, a fund manager drifting between asset classes presents a problem.

The practice of investing bond fund assets in stocks is perfectly legal, but for investors who are not paying close attention it can breach a more fundamental rule of investing: Know what you own.


David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email


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