These Bond Funds Have a Built-In Advantage

Interest rates have hit near-zero rates, and while these rock-bottom rates bode well for spurring economic growth, yields remain stubbornly low even as investors continue to pour billions of dollars into the safety of bond funds. But interest rates are likely to tick up in the future--a fact that investors cannot afford to discount.

So how can a bond-fund investor maximize returns while also minimizing risk? Past articles on Morningstar.com, such as my colleague Russ Kinnel's recent study, have revealed that expense ratios are highly reliable predictors of a fund's likelihood to outperform its peers. This is especially true in the realm of bond funds. Given the extraordinarily low yield environment, it would be difficult to justify investing in a bond fund whose expenses take a big chunk out of its return. Moreover, managers of high-cost funds might be more likely to take big risks to offset their cost disadvantage than managers of cheaper funds.

To home in on bond funds that have low costs on their side, we used our  Premium Fund Screener to sift through our database for low-cost short- and intermediate-term bond funds.

For our first screener, we set the fund category to taxable short-term bond. We immediately streamlined those results by eliminating all but one share class for each bond fund and requiring that managers have helmed the fund for at least five years. On the fees front, we required no-load funds with expense ratios in the lowest-cost 20% of their peer group. And we layered on several Morningstar risk criteria that excluded all but the funds with the lowest risk. We then added criteria to ensure that the resulting funds would accept new investments and be open to retail investors. Finally, we only included funds with Morningstar Analyst Reports so you could read our research on each fund.

Premium members can  click here to view the results for short-term bond funds.

Below is one of the funds that made it through this screen:

 T. Rowe Price Short-Term Bond (PRWBX)
Expenses: 0.55% | Minimum Investment: $2,500
Ted Wiese has managed this low-cost fund since 1995. He avoids concentrating risk by investing in a variety of sectors, including corporate, government, mortgage, and asset-backed securities, while keeping this portfolio's average credit quality at AA. He avoids making major interest-rate bets, and keeps the fund's duration fairly restricted around the two-year mark. Morningstar analyst Miriam Sjoblom applauds this fund's long-term record, as it has either matched or beaten its peers' performance in the past 10 calendar years. At the same time, she reminds investors that even the most cautiously run short-term bond funds aren't immune to sudden interest-rate hikes given the low-yield environment.

Our second screener uses almost identical criteria to the previous one. However, we did change the fund category to intermediate-term bond. Also, note that the expense ratio requirement of the lowest-cost 20% is lower for this particular category, at 0.45%, than is the case for short-term bonds.

 Click here to run the screen for intermediate-term bond funds.

We highlight two of the funds that passed this screener below:

 Dodge & Cox Income (DODIX)
Expenses: 0.43% | Minimum Investment: $2,500
This Analyst Pick features a stellar long-term record, an experienced management team, low expenses, and above-average income. The fund's strategy is to load up on midgrade corporate bonds and mortgage-backed securities with call-protection features in order to hold on to its bonds for the long haul. And the seasoned team uses a bottom-up, value-oriented approach to security selection; the managers will not invest in a bond unless it has the yield, cash flow, and structure to hold up against various economic conditions. Although Morningstar analyst Dan Culloton duly notes that the fund is not without risk, he calls it a worthy core bond holding.

 Vanguard Total Bond Market Index Inv (VBMFX)
Expenses: 0.22% | Minimum Investment: $3,000
Even though this fund strives to closely replicate the Barclays Capital U.S. Aggregate Float Adjusted Index, the fund still has sample risk because it does not hold every security in the index. Still, Sjoblom points out that this fund's returns have closely tracked the index over the long term and have beaten the vast majority of the fund's actively managed rivals. Although the fund lacks exposure to high-yield or non-U.S. dollar bonds, its seasoned management and excellent record makes this Analyst Pick an excellent choice as a core holding.