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By Christine Benz and Russel Kinnel | 04-29-2015 11:00 AM

3 Great Conservative Bond Funds

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.

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.

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