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New Bond Funds Act Like Bonds Only Better

Fidelity and PIMCO get innovative with TIPS and muni funds.

Russel Kinnel, 06/28/2011

In most ways owning bond funds is superior to owning bonds directly. You get greater diversification so that one issue going bad or maturing at the market bottom doesn't hurt you. You also get better prices--if you think your $20,000 purchase is getting the same treatment as a $10 million purchase from a mutual fund giant, you're deluded. In fact, it's extremely difficult to know if you're getting a good price. And funds offer crucial research--that typically determines what the right price should be--on things like call features, credit quality, and payment structures that you can't get on your own.

However, bonds have a couple of advantages over bond funds. They give you greater predictability about how much you'll have to spend at a certain date. Admittedly, you don't know what inflation will be, so you still won't know how far those dollars will go.

In addition, you can more closely tailor a bond portfolio to your money needs by lining up a ladder of maturity dates. (However, you still face the challenge of losing income as you have to reinvest interest income in small sums or wait until you've accumulated enough to reinvest.)

The other argument for bonds over bond funds is really a canard. They say you get your principal back if you hold a bond to maturity, while mutual fund net asset values fluctuate. While that's certainly true, it misses a couple of key points. First, if you checked the price on your bond each day, you'd see that it goes up and down with changes in the bond market, too. If you hold a well-run bond fund over a similar period, you won't likely lose principal. Second, inflation can eat away at the real value of your bond, whereas a mutual fund will recoup some losses by investing money from maturing bonds and income payments into bonds paying higher yields.

Some innovative new funds aim to capture some of the appeal of the hand-built bond ladder while keeping all the pluses of bond mutual funds. Although they are brand-new, they come from some of the best bond managers around. In addition, you can hop on or off at any time just as with any other mutual fund.

One could argue that the pioneer in all this was American Century, which launched Zero Coupon bond funds designed to act like zero-coupon Treasuries. There's limited appeal to those funds, though, as it is hard to justify the added expenses when an investor could simply buy a zero-coupon Treasury himself. After all, there's no credit research or call research needed. In fact, the funds have had a hard time keeping pace with their Treasury STRIPS benchmarks.

Fidelity Defined-Maturity Funds
Fidelity aims to help you build a better bond ladder with four defined-maturity muni-bond funds it launched last Wednesday.

The funds will target 2015, 2017, 2019, and 2021 as maturity dates: Fidelity Municipal Income 2015 FMLCX, Fidelity Municipal Income 2017 FMIFX, Fidelity Municipal Income 2019 FMCFX, and Fidelity Municipal Income 2021 FOCFX. Soon after the dates of maturity (each on June 30), the funds will be liquidated, and any remaining value returned to shareholders. The funds' aim is to produce as high an income stream as possible up until the maturity date while still maintaining principal. Thus, you can dial in the right maturities for your needs.

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