Total Return Bond Funds Offer the ‘Total’ Package

When you buy a bond, you are essentially lending someone money for a period of time. In exchange for that, investors are provided a series of coupon/interest payments. And on the maturity date of the bond, investors will receive their money back. However, over that period of time—whether that is three months or 30 years—the price of the bond fluctuates. In the case of U.S. treasuries, it has more to do with changes in interest rates and a flight to safety. For other bonds—like corporate or junk issues—individual company-specific factors and credit risks generally drive the bus.

Despite the fluctuations in bond pricing, most investors still focus on the yield of a bond. Well, that was true until Bill Gross launched Pacific Investment Management Co. (PIMCO) in the 1970s and the PIMCO Total Return Fund in the 1980s.

Gross’ approach was to use variables—such as credit ratings, yields, maturities, and duration—to create a portfolio of bonds that didn’t act like the broader index, in this case the Bloomberg US Aggregate Bond Index. The key piece was that Gross wasn’t shy about selling bonds once they hit valuation targets. This created gains for his PIMCO Total Return Fund A (PTTAX) based on not only yield, but price appreciation.

Back in the 1980s, this was a wild concept and finally allowed bond investors to see real total returns (price gains & yield) from their investments.

Since then, Gross’ contribution to the bond world has been emulated by a variety of fixed income managers and funds. But the idea remains the same. A total return bond fund will seek to provide both capital appreciation and income from its investments.

Most total return bond funds fall under the index-plus or core-plus category. As such, they take their investment universe from the Bloomberg Barclays U.S. Aggregate Bond Index. That is, they hold U.S. investment-grade bonds with an intermediate maturity tilt. Some mandates will allow fund managers to make smaller bets outside of these parameters.

In addition, a new crop of total return focused bond funds have sprouted up in the wake of the Great Recession. Dubbed ‘unconstrained,’ ‘nontraditional’ or ‘go anywhere’ bond funds, they have a similar total return mandate; however, they allow fund managers to buy anything they see fit. An unconstrained fund may own U.S. treasuries alongside senior loans, CLOs, and even emerging market debt.

The proof may be in the pudding.

Because managers can be flexible and there is another element to their returns—capital appreciation/preservation—total return and unconstrained bond funds have done pretty well versus the broader market.

The Bloomberg U.S. Aggregate Bond Index fell nearly 4.7% as the Fed raised rates and is down about 14.7% for the year. The average core-plus fund (which features total return funds) is down only about 4.4% and is down about 14.6% year to date, according to Morningstar data. While that may not seem like a big difference, the ability to beat an index over time can add up to bigger gains. Moreover, preventing losses can be a big win in constrained and economically stressed times.

Given that total return bond funds can offer better returns and potentially additional sources of alpha in a fixed income portfolio, investors may want to consider them for their portfolios. However, these are not designed to serve as replacements for a core bond holding like the iShares Core US Aggregate Bond ETF (AGG). It’s best if investors use them as additional spice to a fixed income portfolio. Additionally, the total return approach is better suited for a long-term investment strategy. Investors well into their golden years and looking to derive mostly income from their holdings may be disappointed.

With that in mind, there are plenty of choices to be had. You can certainly go for the previously mentioned PIMCO fund, although it is no longer managed by Gross. Other top choices could include PGIM Total Return Bond Fund (PDBAX) or TCW Total Return Bond (TGLMX). Another choice could be the actively managed SPDR DoubleLine Total Return Tactical ETF (TOTL). Given that a huge part of these funds’ gains come from price appreciation, using an ETF may be advantageous in that they avoid capital gains taxes on investment activity within the fund.

Likewise, the unconstrained bond category is vast with choices. The key is to make sure you check under the hood, look at expenses, and understand how a manager has done over long periods of time.

Long-term investors looking for a bit more from their fixed income holdings may want to consider total return bond funds. The additional gains from capital appreciation and the ability to look outside the major indexes can and do pay benefits for portfolios.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.