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3 Great Conservative Bond Funds

Fri, 15 May 2015

Low-cost bond funds like Vanguard GNMA, Fidelity Intermediate Muni Income, and Dodge & Cox Income can provide much-needed diversification to an equity-heavy portfolio, says Morningstar's Russ Kinnel.

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Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the Federal Reserve poised to raise interest rates, these are tricky days for bond investors. Joining me to share some favorite conservative bond fund picks is Russ Kinnel--he is director of fund research for Morningstar. Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: So, Russ, before we get into these ideas for investors who want to be conservative with their fixed-income portfolios, let's just talk about why investors should even think about owning bond funds right now versus just owning cash instead.

Kinnel: Well, you're right--the yields are not great. So, it's not an exciting time to own bond funds, but diversification is generally a good idea. It has worked through a lot of times. And it's good to remember equities have had a tremendous rally. We don't know when the next equity correction will be, and that's a good time to own bonds. Having a little income, even though it's modest, is another good way to protect your portfolio. So, I think it makes sense to stay with bonds, even if it's not very exciting.

Benz: So, I guess the point is, even though the yields are really low, in some sort of equity-market shock where your equity portfolio really sells off, you actually have the potential to maybe make a little money in your bond portfolio versus cash, which will just kind of hold steady.

Kinnel: That's right. Your typical intermediate-term bond fund is yielding somewhere around 2%, maybe a little more. It's not exciting, but again, if you look at most past bear markets, there are times when those funds tend to not lose much money or maybe even make a little money at a time when your equity portfolio is getting hammered. So, it's just a logical thing, and also if you are near retirement or close to retirement, you've got to have something in more stable asset classes like bonds.

Benz: So, let's get into these specific ideas. Vanguard GNMA (VFIIX) is at the top of the list. Let's talk about what specifically that fund invests in because it is somewhat narrowly focused. What do you think is the case for it in a portfolio and why is it a good conservative pick?

Kinnel: So, a GNMA portfolio means you're getting mortgage exposure but backed by the federal government. So, there's very little credit risk, but you do have some interest-rate risk, you do have some prepayment risk. And then also, big picture, you look at it versus a typical intermediate-term bond fund and think, "Well, a typical intermediate-term bond fund is going to have some in GNMAs."

I think that's OK, but it's worth noting, say, a more Treasury-heavy fund or even a Vanguard Total Bond Market (VBTIX), for instance, has about 20% in Fannie Mae and Ginnie Mae debt. It doesn't sound like that much overlap, but because they are both very government-heavy, the funds tend to perform very similarly. If you look at calendar-year returns, you'll see very similar movements. So, I would definitely keep that in mind if I've already got a big stake in, say, Vanguard Total Bond or some other Barclays U.S. Aggregate Bond Index fund. [In that case,] I probably don't want a GNMA fund, or I just want a pretty small stake because the behavior is similar enough.

Benz: But you could reasonably hold it maybe alongside a broad, actively managed intermediate-term bond fund where maybe there is more credit risk in that portfolio?

Kinnel: That's right. If I've got another fund that's, say, taking more risk--either trying to make macro calls or it's got more credit risk--the GNMA fund is going to be a nice diversifier with very little credit risk. It's a very steady fund. And, of course, it's got really low expenses, which is not a bad thing in today's yield environment.

Benz: So, one thing we saw from this fund and a lot of government-bond funds during the 2008 financial crisis was that they held up great. They really were terrific ballast for investors' equity portfolios. But going forward, when you think about rising interest rates, do you have any sense of how a fund like this might behave in a rising-rate environment?

Kinnel: Well, we got a glimpse of that in 2013, where rates spiked a bit and the fund lost about 2.25%. So, we got some idea, but obviously rates can rise a lot more than that. It's got a duration of about 4.5%--that means it's got some interest-rate risk. So, if rates rise a lot, it will probably lose some; but I don't think it will be a disaster. That's the point of, say, choosing an intermediate fund over a long-term fund. You're taking a bit of interest-rate risk, but not a lot. So, you should do fine. But understand there will be some volatility.

Benz: Dodge & Cox Income (DODIX) is also on your list. Let's talk about the case for this fund. It's been seeing big asset inflows. Why do investors seem to be gravitating to it, and why have we assigned it a Gold rating currently?

Kinnel: We're big fans of Dodge & Cox because they do great issue selection, and that's what this fund tries to do. It tries to pick corporates--it's about 40% in corporates--and it's got mortgages, Treasuries. You're not too far from your typical mix, but it does lean more on corporates. That allows it to have a little more yield, and it's had a little better performance. But, obviously, there is a little more credit risk. It does have about 10% in junk bonds, so that's a little more risk. But I also think diversification, in general, can help you with a bond fund, even if that's into a lower-quality investment. Ten percent, after all, is not a huge risk.

Benz: You mentioned the credit-quality risk: When you look at its average credit quality today, it's BBB. That's not a junk rating, but it's not high either. What should investors think about a portfolio like that? How would they expect it to behave in an equity-market sell-off? Would it deliver the diversification?

Kinnel: Well, it did very nicely in '08. I think, certainly, it would be in a little more stress because obviously corporate bonds are a little more equitylike. It depends on if that equity correction happens at a time of economic distress like we saw in '08--in which case that would put a little more pressure [on the fund]. But if it was more of a valuation-driven correction where the economy wasn't a disaster, then it might not be hit that hard. But, yes, there is a little more correlation with equities. But, again, if you look at the return pattern, you can see that generally it's done pretty well even in equity sell-offs.

Benz: The last fund on your list is Fidelity Intermediate Municipal Income (FLTMX). We have very high ratings on Fidelity's muni funds as a group. Let's talk about the case for this particular fund.

Kinnel: I chose the intermediate fund again, thinking about taking a little less interest-rate risk. It's a fund that has pretty high-quality munis; it's got a little lower quality, but it's still a pretty good portfolio. The thing is that Fidelity is just an outstanding muni manager. They've got great managers and analysts there. They don't take big bets. They are very much focused on issue selection, and they've got the low costs to make that work. So, the funds are pretty nice performers. They tend to be on the conservative side of their category, so in credit downturns or interest-rate spikes, they tend to outperform. That's another good thing about it. So, I just have a lot of confidence in Fidelity.

Benz: You've mentioned expenses, expenses, expenses in the context of all three funds. Let's talk about why expenses are so important for bond-fund investors today.

Kinnel: I mentioned that, in an intermediate fund, you've got a yield of about 2%. If you're looking at an intermediate muni fund, it's maybe a yield of 1.5% or 1%. So, if your expenses are 20 or 30 basis points, that means you're paying out a little. If it's 80 basis points, then a big chunk of your income is going to go to the fund company instead of you. So, really, it's one way to improve your yield and improve your returns without added risk. Conversely, funds that have higher expense ratios actually tend to take on more risk. So, in order to get you the same amount of income, they're going to give more risk. That doesn't seem like a good equation to me.

Benz: Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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