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By Christine Benz and Eric Jacobson | 08-04-2014 02:00 PM

4 Off-the-Radar Bond Funds Worth a Closer Look

Some smaller bond funds have the potential to give investors more bang for their buck.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Not every good bond-fund manager is swinging around hundreds of billions of dollars. Joining me to share some off-the-radar bond-fund picks is Eric Jacobson; he's a senior analyst for active strategies at Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: It's great to be with you, Christine.

Benz: Eric, let's set this up for our viewers and talk about why one would even consider a smaller bond fund when you've got these very large, proven quantities that you could invest in instead.

Jacobson: Well, the case is not quite as strong probably in those big, core areas. As you say, we have some big [bond funds] that have very good records, but some of it is personal taste. There are people who want to try and see whether they can do a little better than, say, Bill Gross at PIMCO Total Return because it's so big, and so forth. There are some advantages with size at that core-fund level, but where it really starts to matter is for other kinds of categories.

Benz: So, being small is an advantage in which types of categories, generally speaking? The less liquid categories?

Jacobson: Well, it's interesting because that's kind of a balancing act. You don't want to be too illiquid, obviously; but one thing that you can do with some of these smaller categories is you can buy bond deals or loan deals, for example, in the bank-loan space that are a little bit smaller in terms of the whole issuance. And the reason that that may be an advantage is that you can get a little bit more bang for your buck. You can hold a little bit more of it--a larger position than, say, maybe you would be able to build up in a really big fund, where you could be buying millions and millions of dollars in bonds and you're still only 20 basis points, or 0.20% of the whole fund or something.

Then, the other issue too, of course, is not unlike small caps on the stock side, for example, there are companies that are not well covered, especially if they are not public and they have debt outstanding. You can really uncover something potentially as a really strong manager with good research, and that can be really additive to the results of a good small fund.

Benz: Big funds can do that research too, but they may not be able to get that much bang for their buck by uncovering one of those smaller, off-the-radar-type holdings.

Jacobson: That's exactly right. Obviously, we use PIMCO Total Return as a big example all the time, but it is a key one to look at because if you just look at individual names, for example, if they wanted to do it all in cash bonds, there's a relatively limited set of corporate issuers--just as an example--that they could really build up much of a position in. Well, the good news is that you can use derivatives and so forth, but the single-name credit default swaps in the corporate bond market aren't as popular as they used to be; they're not all that liquid. PIMCO makes up for it with good macro calls and sector decisions and things like that most of the time. But it's a challenge for them to do that kind of thing, whereas a relatively small fund has a lot more choices and options and things like that.

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