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UNTIL RECENTLY, BOND-FUND MANAGERS could get away with one of the biggest shortcuts in investing: skimming over the finer points of each bond they put in their portfolios. Bond research, also known as credit analysis, is supposed to answer a basic question about every bond: How likely is a company (or country or pool of mortgage holders) to pay back its debt with interest? For years many investors didn’t notice or care that fund managers couldn’t always answer that question, because bond funds rarely lost money. But during the financial meltdown, the difference between a bond
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fund earning 5 percent and losing 35 percent, analysts say, often rested on whether the fund managers did their own research. “It’s hugely important, and no one realizes it,” says Lawrence Jones, the head of fixed-income analysis at Morningstar.
The problem, some say, is that too many bond funds essentially have let credit-rating agencies do too much of their bond research for them. The agencies, including Standard & Poor’s, Moody’s and Fitch, judge the creditworthiness of the debt issuer and assign the bonds a rating. But critics have contended the ratings agencies’ research is too slow, flawed or both. Exhibit A: When the credit markets crashed, even many highly rated bonds (including Lehman Brothers and AIG bonds) tanked, taking funds that had leaned too heavily on the published ratings right along with them. For their part, the agencies say their ratings reflect a company’s most recent financial situation and are not intended to be forward-looking.
Having an in-house research team doesn’t guarantee success, but many top-notch bond firms believe it helps keep them a step ahead. Pimco (LTPZ), which manages $841 billion, boasts that it doesn’t even subscribe to the published ratings, instead relying on its 60 analysts. So far, so good. Pimco managed to sidestep the worst of the mortgage crisis, in part because it dispatched analysts to interview mortgage brokers and real estate agents nationwide. Similarly, the Harbor High-Yield Bond fund (HYFRX) has benefited from the expertise of its subadviser, Shenkman Capital, a group dedicated to bonds issued by companies most at risk of bankruptcy. The fund won’t invest until an analyst has met with management, scoured the legal documents that establish who gets paid and how much if a company goes under, and written a 15-page credit analysis. Finally, no manager can buy a bond until the Shenkman credit committee gives approval. Other firms, such as BlackRock (BLK) and TCW (TSI), are known for their research groups, and T. Rowe Price (TROW) has a noted emerging-markets debt team.
Of course, no fund manager will cop to leaning on research from ratings agencies. To find an independently minded bond fund, experts suggest comparing a fund’s holdings against the index. The closer a fund is to its benchmark, the more likely the managers are to be using the consensus research rather than forming their own opinion.
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