Bonds are crucial for diversifying your portfolio, but it can be dangerous to invest in a fund full of stuff only a rocket scientist can understand. By Jeffrey R. Kosnett, Senior Editor May 20, 2008 When it comes to bond funds, observes Bill Kohli, manager of Putnam Diversified Income Trust, "there is value in the complexity." That is to say, the more unusual the securities that Kohli and his team of analysts buy for their fund, the better it is supposed to perform. If only the results bore him out. Kohli's fund, which Morningstar calls a "multisector bond fund but which could easily be called a black-box income fund," is struggling. Over the past year through May 16, Putnam Diversified Income (PDINX) produced a total return of -0.2%. That trailed the Lehman Brothers U.S. Aggregate index by 7.4 percentage points. The fund outpaced the Lehman index over the past five years, to the tune of 1.9 percentage points per year, but trailed it over the past ten, by an average of 1.4 points per year. Granted, Putnam's losses haven't been catastrophic. This is no Regions Morgan Keegan Select Intermediate Bond, which has lost 79% over the past year, or Schwab YieldPlus or SSgA Yield Plus, each down 30% over the past year. All of these funds suffered because of holdings that were closely tied to subprime mortgages. But because Putnam Diversified Income invests in some unusual securities, it is a good starting point for a debate between advocates of institutional-style fund management and those who prefer to keep it simple and cheap. The latter say that most income investors should just build a ladder of corporate, government or municipal bonds or buy a mutual fund or exchange-traded fund that tracks a well-known bond index. Advertisement Putnam Diversified Income's objectives are plain enough: Generate more income than you can get from a regular bond fund of similar or longer duration (duration is a measure of interest-rate sensitivity; the longer the duration the more volatile a bond or bond fund's price with changes in interest rates). Putnam Diversified Income's current yield is 5.7% and its duration is 5.6 years. Compare that with the 6-year duration of a typical corporate-bond fund, such as Eaton Vance Investment Grade Income (EIEIX), which yields 5.4%. Putnam isn't kidding when it calls this fund "diversified." The latest annual report needs 35 pages to list the $2.3-billion fund's schedule of investments. These go from the simple to the inscrutable. There are a few regular government bonds, from the U.S. as well as from foreign nations spread from Canada to Ukraine. There's a smorgasbord of corporate debt, foreign and domestic, high-grade and junk, short-term and long. Then the fun starts. You see collateralized mortgage obligations, securitized asset-backed receivables, forward currency contracts, interest rate swaps, options on interest rate swaps, and my favorite, a "total return swap." No, the fund's not trading returns. This device is described as follows: Putnam Diversified receives ten basis points (0.10% to you) plus "the change in spread of Banc of America Securities AAA 10-year index multiplied by the modified duration factor" over the life of the swap. Advertisement What's actually going on here is this: The fund wants to invest in the triple-A rated layer of commercial mortgage loans, but not for 20 or 30 years. These mortgages have been trading at an unusually high yield relative to other triple-A debt instruments since the onset of the credit crunch last summer. Why? Investors have recoiled from all mortgage-related securities, although there have no defaults in the highest-rated part of the commercial mortgage universe. With the total return swap, the fund pockets the spread, which is around two percentage points minus the cost of cash for the term of the security. Kohli's objective is to exploit "a significant disparity between cash and synthetic instruments" (meaning the total return swaps or other similar constructions) and boost the fund's income and return without extending its duration. Every little bit helps because "we don't want a dominant source of return." In all honesty, neither Kohli nor any other bond-fund manager I've ever met expects ordinary investors to understand how a fund's gears turn. Kohli reasons that his investors are paying Putnam 0.56% a year in management fees (that's part of this share class' annual expense ratio of 0.98%; total expenses differ for other classes) because Putnam does what you cannot do. Advertisement Kohli grants that his fund's recent performance stinks. For this he blames the "messy" and "volatile" markets for mortgage-backed securities and other derivatives, which account for more than half the fund's assets. By no means is Putnam the only black-box fund with problems. Diamond Hill Strategic Income (DSIAX), which has had three losing quarters in a row, is ditching some of its preferred-stock holdings and cutting down on risk in general. Transamerica Flexible Income (IDITX) has lost 3% over the past year, also hurt by declines in its preferred securities. Pimco Diversified Income (PDVAX) has returned 3.7% over the past year but trails the Lehman index by 3.5 percentage points. The Pimco fund holds a lot of stuff you'd recognize but also owns a bunch of currency options and swaps and hedges. You get the idea that the Pimco people can do whatever they please in this fund. Sometimes, their picks work, sometimes they leave you shaking your head. (The words "Pimco's financial engineering maturity estimations" appear among the fund's quarterly holdings). Advertisement Over time it's hard to say whether these multi-sector funds have done better as a class than ordinary bond funds or the indexes because the funds change their ways. Alliance Bernstein High Income has a good long-term record but that's because until 2007 it focused on emerging-markets bonds during a period when that was a good thing to do. Since then, the fund has had a much-tougher going. One thing is for sure: Many advisers, perhaps most of them, believe that the notion that you should avoid investments you don't understand holds as much for bonds and bond funds as it does for stocks, options, futures or real estate. Tim Brown, of Brown Wealth Management, in Eden Prairie, Minn., likes to use funds, such as those from Dimensional Fund Advisers, that resist fads or the temptation to invent financial instruments. "I won't be a guinea pig and my clients don't want to be one, either," says Brown. If you invest in an overly complex fund, you're apt to be not a guinea pig but a sacrificial lamb. The way to avoid this is to either buy an index fund that covers a wide variety of bonds without owning derivatives, or to build a ladder of government and high-quality corporate bonds that pay you interest every month (you stagger the payment dates) and are of limited maturity. Kohli points out that most people don't have any experience buying any kinds of bonds other than Treasury bonds and that Treasuries aren't a good choice right now. But with a little help from an adviser or financial planner, you can learn how to buy bonds on your own. And then you won't have to worry about the possibility that you'll lose 4% some quarter because of indecipherable "swaptions" or what-have-you.