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Jacobson's Picks for Core Bond Exposure

Tue, 8 Nov 2011

Morningstar's director of fixed-income research offers his tips for selecting a solid core bond fund along with some of his favorite choices.

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Video Transcript

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

We're focusing on fixed income all this week, and joining me to discuss how to find a good core bond fund, as well as to share some favorite picks, is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Glad to be with you, Christine.

Benz: So, Eric when you hear this term "core bond fund," let's talk about what types of funds typically fall under that umbrella?

Jacobson: I think it's important for people to think about this because if you go with one or the other, you may have to build some more things in your portfolio. So, for example, we tend to think about and talk about government funds as being firmly core because they really are at the center of a portfolio in most cases. But if you buy one of those, you don't want to give short thrift to adding a couple of additional funds, maybe what we might call satellite funds, to make sure that you are rounding out the bond portion of portfolio--especially if you are one of these folks, like ourselves, who are getting to the point where you need more bonds in your portfolio, and as you get closer to retirement, especially, you don't want to kill your diversification just by holding government bonds.

What we also as tend to call core funds are those in the intermediate-term bond category, those that usually benchmark themselves against the Barclays U.S. Aggregate. And the simplest version of that ... what we say institutionally is "actual core" would have the same sectors that are in the Aggregate. So, that would be government mortgages, Treasury bonds, high-quality corporates, a little bit of commercial mortgage-backed securities and the like, but very little in terms of what we might call the "plus" sectors that you'll find in so-called "Core Plus Funds," which would include, for example, PIMCO Total Return.

And a fund like that might also have some exposure to high yield, non-U.S.-- especially non-dollar, so in other words some foreign currency risk--and potentially emerging-markets bonds, and maybe some in non-agency mortgages.

Benz: Okay. So, it sounds like in any case, whether you are building a multifund portfolio that's going to be your core, or whether you're maybe looking to one or two funds to be the core of your portfolio, that intermediate-term bond category is really going to house most of these funds?

Jacobson: That's right. That makes the most sense, partly because of the sector diversification and also because of the placement in the maturity spectrum and interest-rate sensitivity.

You don't want too little because you just won't get enough to support your portfolio, but you don't want too much because then you're adding so much volatility.

Benz: Okay. So, let's get into some specific ideas, Eric, some funds that you really like within the core bond sector. Let's start with funds that fall under that "Core Plus" banner?

Jacobson: Sure. The "Core Plus" banner is a well-worn area, and we just mentioned PIMCO Total Return, and as a lot of people know, we like to recommend that they look at Harbor Bond, which is also sub-advised by Bill Gross, as well as Managers PIMCO Bond.

And the reason that we mentioned those is because they have very low minimums, and they are available to a lot of people more easily, for example, than PIMCO Total Return. They may be on some of the platforms that people get on through the brokerage firms. Whereas a lot of folks do have access to PIMCO Total Return in the load share classes or even the no-load share classes that have much higher fees.

If you're really lucky, you might have the institutional share class or one like it in your 401(k) plan. If you do, you definitely want to take advantage of that if you like that fund, as we do.

One of the other funds that we really like is Metropolitan West Total Return. That fund is available through a lot of different venues as well. And ... these are both in the "Core Plus" areas I discussed.

Benz: So, Eric, I know that active bond managers in general are not having a great year against the Aggregate Bond Index. What's your take on what's causing that, and is that reason to maybe just look at a bond market index fund instead of monkeying around with active managers?

Jacobson: You know, it's certainly a tricky question because there really isn't anything wrong with bond indexing in the sense that if you get a good fund that's very inexpensive, you can match the benchmark, and 2011 would have been a good year to do it.

By and large, though, the fact is that the bond market is very inefficient. There are a lot of places that a manager, even investing right alongside the index and investing in the same sectors, can--I don't want to say easily--but with the right research and the right tools at his or her disposal, can beat the index, and I would argue probably a lot easier than it might be for a stock manager--just as I said, because there are so many inefficiencies.

So, especially once you get out of those most generic areas like Treasuries, it really does make sense to buy a well-managed, low-cost, active bond fund in cases where it might not seem as obvious in the equity side.

But like I said, if you want to go that route that we talked about earlier, which is sort of take a fairly plain-vanilla core fund and then add some other funds around it, you could certainly start with a bond index fund like Vanguard Total Bond Market Index and add some other things around the side to spice it up a little bit.

Benz: Are there any other core funds that you like a lot and often recommend to investors?

Jacobson: Sure, a lot of our analysts like Dodge & Cox Income. They also like Fidelity Total Bond. And if you are going to go the route of government funds, you might want to take a look at Fidelity GNMA Fund, Fidelity Government Income, or Vanguard GNMA. Those are all, as the names imply, very mortgage- and very government-focused areas where if you did start with that, you'd want to add something to it.

Benz: Okay. So, let's back up, Eric, and talk a little bit about Dodge & Cox Income and Fidelity Total Bond. What are the key things you like about those two?

Jacobson: Well, the nice thing about Dodge & Cox Income is it's very plain-vanilla as these funds go. It doesn't usually gorge on a lot of extra risk. It doesn't use a lot of derivatives and things like that. It's about as plain-vanilla of a good actively managed core bond fund as you're going to find. ... And Fidelity Total Bond, very kind of similar. Both of these have had their up and down years, where they have maybe been on and off a little bit, but by and large, great long-term records. Fidelity has a really nice, good taxable bond shop that has not ... gotten a lot of attention out in the marketplace, certainly not as much as their municipal group. But they do a very nice job, and it's a real good core area, core holding place to be.

Benz: Okay. Then you mentioned a couple of government funds as well. What are the unifying themes that make those high-quality go-to offerings?

Jacobson: Sure, well, one of the most important things with a government fund is that you'll find that a lot of them have a heavy mortgage emphasis, because mortgages are a big part of the index, big part of the government bond market. What you really want is a well-skilled team. They really need to understand the mortgage marketplace and understand how to manage volatility. These are pretty straightforward fairly basic funds--the Fidelity and the Vanguard funds that I mentioned. They both have really strong teams behind them. There are others that we like as well. PIMCO has a mortgage fund that we like, too, but these are some of the real plain-vanilla versions that you want to take a look at, if you're looking to build out a more complicated portfolio around them.

Benz: Okay. So, in terms of unifying themes among all these funds that make them go-to offerings, I'm hearing you talk a lot about high-quality management, disciplined and seasoned teams of analysts. Low costs, I assume, would also be high on your list of criteria that individuals should prioritize.

Are there any other things you say that people should keep in mind when shopping for core bond funds?

Jacobson: Sure. Well the ones you mentioned are crucial. I would say, first determine the scope of the portfolio that you're looking at, and what is the manager actually saying that he or she is going to invest in? Does it include a lot of these plus sectors like I said earlier: foreign bonds, high-yield, emerging markets?

Now, once you have an idea, what does this fund buy and what it doesn't, does the team that you're looking at have the capabilities to invest well in each of those areas. Or, are they saying, "Yeah, we're going to add a little high-yield. We don't actually have a particularly well known or very good high-yield team. But we think we can sort of do this on the side."

Nobody is actually going to come out and say it that way, of course, but you can read between the lines if you're looking at a fund company that's advertising its core fund, but doesn't have a high-yield fund to speak of, or [doesn't have] one that you know is very good.

Then of course, even if they've got all those things, you want to look and say, have they done a good job of synthesizing this? We're taking a very hard look right now at BlackRock's total return bond funds. Just as an example, we think that they've done a really great job bringing that shop back from some of the troubles that they had in 2008. They've got some great sector teams. They're all doing really, really well when you look at the high-yield, the mortgages, the TIPS, etc. But the core funds, the total return funds--the core and total return funds is actually how they're naming them now--haven't quite done all that well yet. We think there is a lot of hope there. We think that there is a lot of potential for improvement going forward. But that's an example where the two haven't necessarily linked up.

Benz: Okay. Last thing I want to cover with you Eric is, there has been this big vogue for unconstrained bond funds; a lot of new funds have come to market. Some of them have gathered a lot in assets over the past few years. What's your take on using such a fund to fill the core role in a portfolio?

Jacobson: I would really resist the temptation to supplant your core portfolio with an unconstrained or absolute return fund, whatever the marketing may look like. I think the reason for that is just that they haven't proven themselves yet. Some of them have some great potential, but none of them have shown that they really deserve to take up that much of your portfolio.

Benz: So, you would just use them around the margins of an otherwise diversified bond portfolio?

Jacobson: That would be my suggestion.

Benz: Okay, Eric. Well thank you so much for joining us. It's always great to hear your insights.

Jacobson: Glad to be with you.

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

Funds mentioned in this video:

PIMCO Total Return PTTRX
Harbor Bond HABDX
Managers PIMCO Bond MBDFX
Metropolitan West Total Return MWTRX
Vanguard Total Bond Market Index VBTLX
Dodge & Cox Income DODIX
Fidelity Total Bond FTBFX
Fidelity GNMA Fund FGMNX
Fidelity Government Income FGOVX
Vanguard GNMA VFIIX

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