Investor interest in bond funds has been exceptionally strong for the past four years; more than $1 trillion in net sales have flowed into taxable and tax-exempt fixed income mutual funds.

But unlike the rapt attention investors gave to equity funds during their last upturn (during which less popular pockets of the market were explored, puffed up with new cash, and left to catch latecomers as the cycle repeated in yet another "new" opportunity), fixed income fund investors have kept their preferences relatively simple and predictable. They have looked to yield plays in junk bonds and emerging markets on the one hand and the standard diversified portfolio that tracks the Barclays Aggregate on the other. But that "standard" portfolio has changed in important ways over the past several years and has followed investors' preferences for yield as well—clouding perceptions of relative success.

Lipper tracks 173 mutual funds in our Intermediate Investment-Grade Debt category, the home of fixed income portfolios that invest primarily in investment-grade debt (as rated in the top four grades by credit rating firms such as Standard & Poor's, Moody's, and Fitch) and with durations from five to 10 years. These portfolios typically benchmark the Barclays U.S. Aggregate index, which is composed solely of fixed-rate, U.S. dollar-denominated, investment-grade bonds (other frequently used benchmarks are often subsets of the Aggregate). For investors seeking exposure to a broadly diversified portfolio of high-quality bonds, this is the place to be.

But not all fund managers hew to the principle objective of the benchmark, which is to own high quality domestic paper. Instead, managers have bought more debt of lower rated companies and emerging market sovereigns in an attempt (a recently successful one at that) to gain an advantage over the benchmark.

As shown in Figure 1, the proportion of funds in this group having more than 10% of assets allocated to credit plays has increased—from just 6% at the end of 2008 to 35% in mid-2012. Of the 53 managers with more than 10% of assets in risky plays, only one failed to beat the Barclays U.S. Aggregate over the past three years. At the same time, more than 30% of managers with less than 10% in those same risky assets failed to beat the Aggregate. Those with less than 1%—true benchmark believers—were even less successful—they lost out to the index 63% of the time (five of the eight funds underperformed).

One can see how difficult it might be to pass up the opportunity to beat the benchmark. Evidence collected by Lipper over the past three years suggests that managers stand to gain 12 basis points of performance over the benchmark for each 1% of assets in low-quality credits. But it's not just performance against the benchmark that these managers are after: by separating themselves from their peers, performance ranks improve and investors look approvingly upon them for their exceptional acumen.

That perception of skill also means that by taking on lower-quality credit, managers of these funds expose their investors to incrementally more risk (see Figure 2). Fortunately for all involved, that has tended to pay off lately. Plotting these managers' risk (as measured by the annualized standard deviation of monthly returns) against their annualized total returns over the past three years, the more aggressive portfolios have tended to provide better returns for each level of risk compared to their less aggressive peers. Fitting regression lines (red and blue lines) to the two groups, it is clear how much better managers have done by straying outside the lines. And as long as high-yield default rates remain low, this dichotomy is bound to persist. Because this shift into non investment-grade paper largely came after the credit crisis of 2008, the past doesn't provide good examples of how well these managers anticipated or were able to extricate their portfolios from junk bond train wrecks.

Fund sponsors have generally done a good job alerting investors to their strategic intent by naming their funds "ABC Core Bond" or "ABC Core Fixed Income Fund" for funds that don't invest much outside the Aggregate benchmark and "ABC Core Plus" for those that do. But not everyone is so strict. Recently, we counted four "Core Bond" funds with more than 10% in high yield as well as four "Core Plus" funds that held much less than 10% in high yield. Other naming conventions such as "Total Return" or "Intermediate Bond" were scattered among both groups and offered no clarity on the funds' preference for (or avoidance of) lower-rated bonds.

While Lipper continues to study this issue, our research to date suggests it's time to separate these strategies into distinct groups. Whether the line that separates "core" from "core plus" is set at 10% below-investment grade or 5%, we're not yet certain. But what we do know is this: it probably won't be zero. Among all the funds in Lipper's most popular bond fund classification, just one is entirely within the realm of the U.S. Aggregate index as every other manager in this "investment grade" field has taken a bite from the junk bond apple.

Jeff Tjornehoj is head of Lipper Americas Research,
focusing on the United States and Canada. He is a regular
contributor to Lipper's Fund Flows and Closed-End Funds reports.