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By Russel Kinnel | 06-02-2014 10:00 AM

2 Bond Funds for the Cautious

Fixed-income investors should consider playing defense because of potential credit problems or a spike in rates, but there's a risk of being too conservative, as well, says Morningstar's Russ Kinnel.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Bond funds have had a great year so far in 2014, but many investors are still feeling quite nervous about bonds. Joining me to discuss some good conservative bond funds is Russ Kinnel; he is director of manager research for Morningstar.

Russ, thank you for being here.

Russ Kinnel: Good to be here.

Benz: Russ, let's talk about the case for being a little bit conservative with at least part of your bond portfolio. Why would one want to think about being risk-averse particularly right now?

Kinnel: I think there is certainly the danger of another interest-rate spike or credit issues where we'd see some problems with credit quality. So, I think, as you say, you don't necessarily want your whole portfolio to be conservative, but I think it makes sense to play defense. The bond market is not giving you a ton of yield right now, so at least dial down the risk side of the equation.

Benz: One comment I would make is that people were saying, "You need to be really defensive on bonds" even three years ago, and it hasn't been a terrible period for bonds. There have been ups and downs. Certainly last summer was a difficult time for anything with duration in it, but, overall, bonds haven't performed abysmally. Is there a risk to being too conservative?

Kinnel: There definitely is a risk of being too conservative. You need to keep up with inflation, and a conservative bond fund might do that and might even outperform somewhat. But you don't want to just have all your eggs in one basket, and as you imply it's hard to time the market.

I wouldn't suggest these are market timers. I'm not suggesting that interest rates are going to spike up tomorrow. That's really too difficult to call. I think it's more a case of rounding out your portfolio with some conservative investments. I think cash isn't paying you anything. Here are some funds that can lose some money, but they're so conservative they probably won't lose a lot. So it's a nice thing to have as your first step above cash.

Benz: Let's discuss the first of the two that you want to talk about, that's FPA New Income. Let's discuss this fund's mandate, which I think is little interesting and perhaps sets it apart from other bond funds.

Kinnel: That's right. It's not just looking at a straight bond index but also wants to beat inflation by 100 basis points. And it's really kind of an absolute return view. The fund was formerly run by Bob Rodriguez and now Tom Atteberry, though Rodriguez is still in the background there, and they really focus on protecting against losses, and so over the years the fund has become quite conservative. It doesn't want to take on a lot of interest-rate or credit risk. It's really focused on that preservation of capital.

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