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By Russel Kinnel and Christine Benz | 07-19-2017 02:00 PM

3 of Kinnel's Favorite Core Bond Funds

Bonds bring income and ballast to a portfolio that might have gotten too heavy on stocks.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As the equity market has rallied, many investors might find that their portfolios are too heavy on stocks given their targets. Joining me to share some favorite core bond fund picks is Russ Kinnel, he is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, I recently looked at the asset allocation of a portfolio that was 50% equity, 50% bond back when this rally began in March 2009. If you left it untouched, it would be 75% stock, 25% bond today. So I do think investors who haven't revisited their portfolios for a while probably should take a look at their asset allocations. What's the value of potentially adding to bonds at this juncture if you haven't done anything to your portfolio and maybe it's gotten a little bit more aggressive than you need it to be?

Kinnel: Yeah. I think bonds serve a purpose not just of giving you income but they are also a ballast. There are times when equities have gotten crushed and bonds even rallied or sometimes they at least held their value. And so, there is a really tremendous diversification value, especially as you get closer to retirement, but even younger, there's still some value in that it keeps you in the market. And so, there really is good diversification, there is some income. You don't want to have all your eggs in one basket is the simple principle there.

Benz: A lot of investors though today looking at the bond market might not be enticed by what they see. You've got yields that are still pretty low. You also have the prospect of rising interest rates which can hurt bond prices at least in the short term. So, what do you say to investors who say, yeah, I get it, what you are saying about diversification; I just don't like the asset class right now.

Kinnel: I think that's a fair point. So, certainly, yields are not great and there is interest-rate risk. But people have been talking about interest-rate risk for the last eight years and they have barely gone up at all. Meanwhile, people in bond funds have collected decent yields and made decent returns. So, I don't think we're very good at predicting interest-rate spikes. So, I wouldn't let that drive your portfolio. Yes, yields are lower, but again, we are looking at the diversification here. We're looking about dialing down risk of your portfolio and that's, I think, one of the key goals, not just boosting returns.

Benz: OK. So digging into the specific fund ideas, before we get into them, let's talk about when you and the team are evaluating funds, bond funds in particular, what are the criteria you look at when determining what their ratings are?

Kinnel: Well, there are a number of things. I think, obviously, you want a really good mix of strategy and people. So, some kind of strategies, let's say, high-yield or others, really require a lot of humans to go and do a lot of in-depth research. And so, we really look for that kind of combination. Obviously, costs are incredibly important. You mentioned that yields are lower, so costs take away from that yield. Before you get your income from a fund, the expenses have to be paid. And so, those are really important considerations. You want the whole package. And you want something that meets investors' expectations. Wall Street has been pretty good at coming up with funds that are too good to be true because they put out a big yield and maybe they have a safe-sounding name, but actually they are taking on a lot of risks, and bond investors in general hate risks. So, we keep a really close eye on the risk side of the equation here.

Benz: OK. Digging into the specific picks, I thought it was interesting, one of the ideas here is a fund that may not be a household name even for regular Morningstar readers and viewers. This is Baird Aggregate Bond. Let's talk about its attributes. It's an intermediate-term bond fund. Why do you and the team like it so much?

Kinnel: Well, they do a really good job of executing a fairly basic lower-risk strategy. The fund has got low costs. So, they don't have to take on a lot of risk and they don't. And if we're talking about diversifiers, I think let's look for a fund that doesn't have a lot of high-yield exposure or exposure to other higher risk areas. So, this is a fund that's got less credit risk than most of its peers and fairly mild duration risk. So, it's a pretty modest fund, but executes very well and therefore still has pretty good returns.

Benz: So, you mentioned looking at funds that don't take on a lot of credit risk. You're saying that they would tend to be more valuable as diversifiers. They would tend to move not in the same direction as the equity piece of my portfolio. When stocks are going down, they may hold their ground a little better?

Kinnel: That's right. So, when we talk about credit risk, we're really talking about corporate bonds or high-yield, in particular, is where you get credit risk. So, naturally, a higher-risk fixed-income security from a corporation is going to be more like a stock than, say, a Treasury bond or a Ginnie Mae.

Benz: OK. Another pick, this is one more in the realm of tried and true, Vanguard Total Bond Market Index. Let's talk about its attributes, why you think it is an attractive pick, specifically for investors who are looking for that ballast for their portfolios.

Kinnel: Right. Well, more than most intermediate bond funds it's heavily into government bonds and mortgages. And so, those are going to act less like the equity market, obviously. They are also fairly commoditized areas, especially the Treasury side of the equation. And so, when you're looking at commodities, let's look at indexing, let's keep costs as low as possible. So, this plays a nice role in the portfolio driving down costs, giving you some ballast to counteract equity risk.

Benz: OK. So, the first two funds, the Baird Aggregate Bond and Vanguard Total Bond Market Index, those are both intermediate-term bond funds. But you also brought a short-term fund. This would be appropriate for an investor who maybe has a little bit of a shorter spending horizon for his or her money. Let's talk about Vanguard Short-Term Investment-Grade and why you think it can make sense for that role in a portfolio.

Kinnel: Right. Now, this one does have a fair amount of corporate bonds, the majority of assets are in corporates and the rest are in Treasures, but it's high-quality investment-grade corporates. So, even though it's got some corporate exposure, it's still not going to be very much in sync with the equity market. Obviously, low-cost, well-run fund. It's not for excitement that you own this fund; it's for protection. And as you say, maybe this is your first line of defense after you go through, say, your money markets and CDs.

Benz: OK. Russ, important topic today. Thank you so much for being here to discuss these good core bond fund picks.

Kinnel: You're welcome.

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

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