Now, a chance to stress-test a bond fund's portfolio

There's a difference between reacting to short-term market wiggles and overreacting to them.

So while experts routinely tell fund investors to ignore day-to-day deviations, what happens over a month or two can be telling, particularly in bond funds.

And based on what has been going on in the mortgage and credit markets, this is a time for many bond fund investors to react and recheck their position.

That's not a call to sell bond funds, but rather to examine performance more closely, because the wild conditions that the market has lived through since the end of June have created the perfect crucible for stress-testing a bond fund's portfolio and your tolerance for what the fund holds.

If you set aside the headlines tormenting fixed-income land, you can sum up the current situation this way: It's a great time to be a tortoise, the bond markets were so favorable that bond fund managers had an easy time putting up decent results. The hares -- the funds that stretch for extra yield -- were rewarded for taking high risks.

While that appeared to be changing in the early part of 2007, there's no doubt it changed by June 30. That's when the market effectively repriced risk, and a four-year trend of tightening credit spreads effectively reversed itself over the course of a month. As a result, Treasury yields are down dramatically, and when yields fall, bond prices rise.

That's created an interesting situation. Bond funds set their daily share price by "marking to market," meaning they price each bond as if they were going to sell it. When yields come down, prices go up. That helps to explain why the Lehman US Aggregate Bond Index is up 5.6 percent through early August.

Of that move, nearly 100 percentage points occurred in July.

Not all types of fixed-income securities have benefited from the move. Mortgage-backed securities, some junk bonds and other areas that have been captured in the headline risk of the past two months have been hurting. Those types of investments, typically, were the kinds of things that those hares were buying to get the jump on the slow-and-steady crew. Thus, the tortoises among general bond funds have been able to catch up and, in most cases, take a lead.

"With bond funds, this is a time to take your temperature -- in terms of whether you can handle losses -- and then the temperature of your fund to see if it's been running fast and is now out of breath," said Morningstar bond fund analyst Paul Herbert.

And that's why in this unusual case, it's worth looking at short-term performance and drawing conclusions from it.

Even if performance has suffered since June, automatically selling would be an overreaction. Investor nerves right now have more to do with the volatility in the bond market, rather than with actual locked-in losses. Instead, recent performance might be a call to look more closely at the fund and how it pursues its strategy.

Bond funds are inherently murkier than their stock cousins; the average investor can't look at a bond portfolio, pick out a few tickers and get a sense of what the fund is doing. Instead, they could find a bunch of unrecognizable names, representing bonds with any number of embedded features that won't show up when included on a laundry list of holdings.

The performance numbers, however, won't lie. And if they paint a picture of a fund that has overreached for yield and underperformed as a result, react appropriately.

That means calling the fund for a current breakdown on holdings and strategy. There's nothing wrong with holding mortgage-backed securities or junk and more, so long as it's what you expected the fund to do; there's something very wrong with being kicked around because your fund owns securities you ordinarily avoid.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.