Why These Active Bond Funds Are Worth a Premium

An oil refinery and petrochemical plant owned by Petróleos Mexicanos in Houston. (Mark Felix/Bloomberg)

Have investors forgotten the traditional relationship between stocks and bonds?

The S&P 500 index currently has a price/earnings ratio of 23, about the same as it did at the start of 2022’s crash. Yet back then a 10-year Treasury note yielded 1.5%, and today it yields 4.4%—guaranteed.

In other words, bonds are attractively valued, while stocks are not. “Bonds are a great opportunity right now,” says Campe Goodman, manager of the Hartford Strategic Income exchange-traded fund. Outside of Treasuries, Goodman has been buying debt yielding 6% to 7% in such sectors as securitized consumer loans and emerging market bonds.

Normally, investors expect the earnings yield—the inverse of the P/E ratio—on stocks to be greater than bonds to compensate for the lack of guaranteed cash flows. But the S&P 500 has a 4.3% earnings yield, less than Treasuries and considerably less than bonds Goodman owns.

While low-cost index funds like Vanguard Total Bond Market are still reliable holdings, it’s a good time to consider active funds with flexible mandates to play offense and defense. One reason bonds remain cheap is uncertainty about the macroeconomic environment amid a trade war.

The Hartford ETF launched in 2021, but it’s run by the same team at one of the largest active managers, Wellington Management, as the much older and successful Hartford Strategic Income mutual fund. (The ETF’s fees—0.49%—are lower.) Also solid are Dodge & Cox Income and Dodge & Cox Global Bond, which are run by one of the most experienced and deepest analytical teams.

“We’re not a benchmark hugger,” says Dodge & Cox CEO Dana Emery. “We will take bigger positions against the benchmark based on where we’re seeing value over our extended time horizon.” The firm is focused on individual security selection, low valuations, and long-term results, not on macroeconomic top-down sector positioning or collecting yield.

That’s one reason Dodge & Cox doesn’t offer ETFs. The managers don’t want to reveal their individual positions with daily portfolio transparency as they slowly buy the cheapest bonds. For instance, both mutual funds are longtime bondholders of Petróleos Mexicanos, which carries a lot of leverage on its balance sheet. Yet as the nation’s major state-owned oil producer, it is structurally important to the Mexican government, which is unlikely to allow it to fail. The bonds Dodge & Cox owns yield about 10%, but it required time to build a position at a good price.

10 Actively Managed Bond Funds for This Market

These funds have the flexibility to navigate a challenging macro environment.

Note: Returns are as of July 11; three-, five-, and 10-year returns are annualized. *Prospectus expense ratios include leverage costs at some funds such as Pimco’s. Without leverage, fees are lower. N/A=not applicable. **These ETFs have the same managers as their namesake mutual funds, but their strategies can differ.

Source: Morningstar Direct

Liquidity is always challenging for institutional bond buyers outside of Treasuries and the largest corporate debt issuers. “When I look at what’s going on in the ETF space in terms of very illiquid investments making their way into daily liquid ETFs”—collateralized loan obligations, complex option strategies, private investments—“I’m concerned,” says Daniel Ivascyn, manager of the $188 billion Pimco Income mutual fund.

He also manages the $6 billion Pimco Multisector Bond Active ETF, though he stresses that the mutual fund “is a highly flexible strategy, very tactical, very active.” The ETF’s strategy is longer-term-oriented. Its expense ratio of 0.55% is lower than the 0.90% charged by the mutual fund’s retail A-share class.

Ivascyn’s team has long profited from its bets on securitized mortgage and consumer debt—home, auto, and credit-card loans bundled as tradable securities. The ETF has a 40% weighting in such debt, according to Morningstar. “We know that government balance sheets have weakened considerably [since the 2008-09 crash], and corporate balance sheets have deteriorated,” he says. “But the consumer balance sheet has only improved.”

There are other sectors worth exploring today, Ivascyn says, especially overseas, where investors can find not only better yields but also cheap currencies relative to the dollar. Although he thinks the road will be bumpy, over the next five years, he says, “one of our highest conviction views would be dollar weakness.”

Another excellent fund/ETF pair is the Eaton Vance Total Return Bond ETF with the ticker EVTR and the mutual fund EBABX, but they are also not identical. “There are certain sector limitations, for below investment grade [high-yield debt] in the mutual fund that can be up to 35% but in the ETF can be up to 20%,” says Vishal Khanduja, the funds’ manager. He also likes foreign bonds, in particular European banks such as BNP Paribas, Swedbank, and Intesa Sanpaolo, which have attractive valuations.

The yield-hungry might consider Vanguard Multi-Sector Income Bond, which mimics the older mutual fund with the same name. Manager Michael Chang says the two funds will have different portfolios initially as the ETF only launched this June while the mutual fund in 2021, so it has older bonds. But in time the two strategies will converge.

Chang isn’t focused on Treasuries or mortgage debt. “Our neutral position is 100% credit-focused, about half of that in high-yield corporate risk, 30% of that in investment-grade corporate risk, 10% in emerging markets risk, and about 10% in structured-products risk.” The highest-quality corporate debt provides liquidity to manage the fund in an ETF form, while still providing extra yield.

The mutual fund and ETF both recently had an SEC yield of 5.5%. With a 0.30% expense ratio, the ETF is one of the cheapest active bond ETFs.

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