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Our Best Fixed-Income Ideas for IRAs

Sarah Bush
Christine Benz

This presentation is an excerpt from our Premium-member webinar, Top Ideas for Your IRA.

Christine Benz: Hi, and welcome back. I'm joined now by Sarah Bush. She is director of fixed-income strategies in Morningstar's Manager Research Group. Sarah focuses on bond funds, and she's brought with her some of her best ideas for IRA contributors in the realm of fixed income.

Sarah, thank you so much for being here.

Sarah Bush: Thanks so much for having me.

Benz: Sarah, before we get into your picks, I get this question a lot. What's the case for fixed-income investing right now? Investors are worried about, potentially, how rising interest rates could affect their bond portfolios. They're asking me whether they shouldn't just invest in dividend paying stocks instead? What's the case for bonds as part of a portfolio?

Bush: That's a great question, and we're very sensitive to that this year. We've seen losses in a lot of fixed-income bonds. I would first of all say, with yields going up, it's actually a better time to be investing in bond funds. Yields are the number-one predictor of the types of returns you're going to see over the long haul in bonds, so rising yields are actually a good thing. Then, I think investors need to think about their overall portfolios. If bond funds are providing a diversification role in your portfolio, that doesn't change when we see some moves in interest rates. High-quality bond funds tend to do very well during periods of equity market turbulence.

Even if you look at what we've seen so, year to date, the Agg's down 2%, that doesn't feel good, but when we've seen volatility in equity markets, sometimes we've seen S&P 500 move by that much in a day. Bond funds, even when they're doing badly, high-quality bond funds--I want to make that distinction--tend to hold in pretty well and provide that ballast in your portfolio.

Benz: You mentioned the Agg, and that is Bloomberg Barclay's Aggregate Index. That's kind of a core index that bond funds benchmark themselves against. Let's get into your picks. At the top of your list is Fidelity Total Bond. The ticker is FTBFX. It's intermediate-term bond category. We rate it as Gold. What's the case for this fund?

Bush: Fidelity has just really broad resources across a number of fixed-income sectors. They're very good at investment grade and high-yield credit. They've got a good mortgage team. They've seen a little bit of turnover there, but they've got a very strong mortgage team, and they've got a good emerging markets team. Fidelity Total Bond is what we call a core plus bond offering. It goes beyond the Agg that we were talking about. That's all investment-grade, dollar-denominated securities. It can invest in high yield and invest in emerging markets. Manager Ford O'Neil, who's been there a long time, has done just a really great job with that tool kit. He's been sensitive to valuations, not always risk on. Then, the fund's also very cheap, which is clearly really, really important for fixed-income options.

Benz: I asked you to categorize your picks as either core or noncore. You would put this one is the core category, so if I need some ballast to offset what might be going on in my equity portfolio, this is pretty good idea for that slot.

Bush: Absolutely, although I will point out that because it has this core plus, it has that flexibility to do high yield, there are certain periods of credit stress that it may under perform a pure investment grade indexlike option, so that's something to be aware of.

Benz: Good to know. The next core bond fund pick that your brought is Western Asset Core Plus Bond, ticker WACPX. Also Gold rated, also lands in our intermediate-term bond category. This one just got an upgrade to Gold. Let's talk about why you and the team think it's a good core fixed-income pick.

Bush: When you're looking at these core, and this again is a core plus fund, we see a lot of the same things we see at Fidelity: just depth in a number of different areas of the market. This one, good credit team. They do a little bit more on macro, so they're doing a little bit more work on trying to anticipate where interest rates are going to go. Fidelity doesn't do that. They've done pretty well with that, and so I think that's another strength of this fund. This one also goes a little bit further. It will do some non-dollar currencies, in small amounts, and a little bit more of structured credit. Those nonagency mortgages, which got into a ton of trouble during the crisis, but managers who've invested in them since then have actually done very well. It's been a nice performing part of the market.

Benz: Last question on this one is the share class that I just referenced, that WACPX, that has a $1 million minimum. For people who aren't in a position to buy that, can you buy it somewhere else with a lower minimum? And then what are the costs like, if I'm in a lower minimum share class?

Bush: That's a good point. There's an A share class on this fund. It is available through some of the NTF platforms. (non-transaction fee) Including Vanguard and Schwab, but you do want to be a little bit more careful, because the expenses are a bit higher in those A shares. That's something that those investors should be thinking about.

Benz: If you move away from the institutional share classes, you sometimes get a little bump up in the expense ratio. A pair of funds that you think are good core ideas, both from Baird, Baird Aggregate as well as Baird Short-Term Bond, these aren't household names among bond investors. Let's talk about why you and the team like the team at Baird so much, and why you've given both of these funds Silver ratings.

Bush: Baird is a very straight forward shop. It's based out of Milwaukee. A very experienced management team, a very straight forward approach to bond investing, so you're not going to see derivatives in these portfolios. I mention that Western, for example, has used currency which some of the other competitors have. These guys don't do that at all. They don't make big macro bets. They're duration-neutral, so they're not trying to take a view on what's going to happen with interest rates. Very plain vanilla, kind of focusing more on credit selection, making the right call, which maturity bonds are more attractive today. Again, not making those interest rate bets, but where are you getting paid for that risk. They're very cheap, so they don't have to do as much. They don't need all the bells and whistles of all these moving pieces, because they're really quite affordable. This is a shop we really like.

I would also point out that Baird Aggregate Bond, in particular, this is a fund that doesn't do any below investment grade debt, so I would think of this, this is not a core plus fund. This is a fund that really is focusing on that investment-grade, high-quality part of the market. That's the part of the market you'd expect to do really well when you get those equity sell-offs, so very good for diversification.

Benz: That's a great point. If I've done my homework, and my X-ray has come back saying you've got way too much in equities, you need to get some bonds. Something like this would be an appropriate choice. Those are all great core fund ideas. You also brought a couple of non-core. Maybe sort of peripheral players. Let's start with the first, Templeton Global Bond. This fund's ticker is TGBAX. It lands in the world bond category. It's Gold rated. Its fortunes tend to kind of wax and wane, because it does have a very idiosyncratic strategy. Let's talk about that.

Bush: This is a global bond fund, so can invest across the world. It has, in recent years, really held large stakes in emerging-market stocks, so I would think of this as a diversifier. The manager there, Michael Hasenstab, has been very cautious and concerned about rising interest rates and risks for inflation. If that's a concern that you have in your portfolio, this is a fund that expresses that view. I think it's kind of an interesting play for diversification. If you want a little bit of emerging markets exposure in your portfolio, it's good. But you've got to have a lot of patience with this one. This is the kind of fund you should not be buying based on recent performance, and you should really be willing to hold over the long haul.

Benz: It's performance will tend to be not so much bondlike, as maybe a little more equity like; so I need to be prepared for that as well.

Bush: Right, right. You can see that volatility. This is another fund too, just to highlight, there's a lot of non-dollar currency in it. That's what gives it a lot of the volatility, is having that exposure to non-dollar, both long positions and short positions.

Benz: That's been helping it recently no doubt, but it presumably has hurt it at other points in time.

Bush: Right. There's times where that's really hurt the portfolio.

Benz: Let's look at another fund. A little less sexy, I would say, than that Global Bond Fund. Vanguard Short-Term Inflation-Protected Securities, VTAPX is the ticker. That lands in our inflation-protected bond category. It's Gold rated. Let's talk about why someone might look at this fund, and why someone might look at TIPS in the first place, because they really haven't performed well, treasury inflation-protected securities.

Bush: This is a place, where if you're just going to look at trailing returns, which we really don't think people should, you might overlook. Inflation is the great enemy of a bond portfolio. It's eroding your purchasing power. It's something all investors--all investors, all portfolios--need to be thinking about. Although inflation has been muted, and inflation expectations, though they picked up a little bit, have been muted, this is kind of a great insurance policy for your portfolio. We don't have a crystal ball. We don't know what's going to happen in the future. This is the type of investment that's really going to help insure your portfolio, if we do get an unexpected increase in inflation.

Benz: In contrast with a lot of the core TIPS products, this one's not going to be super interest-rate sensitive, because it's focused on the short-term bonds.

Bush: Right, and TIPS, this is something you have to be aware of with TIPS, the sort of longer term TIPS products can be very volatile. Although they're protecting you from inflation risk, you can still see a lot of volatility. This fund is less volatile, and another interesting thing about it, which Vanguard did a bunch of research before they launched it; they pointed out that in fact the short-term TIPS are a little bit more responsive to changes in inflation, so it actually does a really good job of providing that protection without the same kind of volatility that you might see in a longer term fund.

Benz: An IRA is really an ideal receptacle for a holding like this, because of some of the tax considerations. You're not going to find a Treasury Inflation-Protected Securities fund in many 401(k) plans. If you're looking to kind of populate areas that your 401(k) doesn't provide, this is maybe a category to give a look to.

Bush: That's absolutely right. You do have to be cognizant of those tax issues, so an IRA is a great place to hold these.

Benz: Sarah, always great to get your picks and your insights. Thank you so much for being here.

Bush: Thanks, Christine.

Christine Benz: Hang on for a second. We're going to be bringing Dan Rohr out here to share some individual stock picks. He will be joining us momentarily.