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Fund Spy

New Bond Funds Act Like Bonds Only Better

Fidelity and PIMCO get innovative with TIPS and muni funds.

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In most ways owning bond funds is superior to owning bonds directly. You get greater diversification so that one issue going bad or maturing at the market bottom doesn't hurt you. You also get better prices--if you think your $20,000 purchase is getting the same treatment as a $10 million purchase from a mutual fund giant, you're deluded. In fact, it's extremely difficult to know if you're getting a good price. And funds offer crucial research--that typically determines what the right price should be--on things like call features, credit quality, and payment structures that you can't get on your own.

However, bonds have a couple of advantages over bond funds. They give you greater predictability about how much you'll have to spend at a certain date. Admittedly, you don't know what inflation will be, so you still won't know how far those dollars will go.

In addition, you can more closely tailor a bond portfolio to your money needs by lining up a ladder of maturity dates. (However, you still face the challenge of losing income as you have to reinvest interest income in small sums or wait until you've accumulated enough to reinvest.)

The other argument for bonds over bond funds is really a canard. They say you get your principal back if you hold a bond to maturity, while mutual fund net asset values fluctuate. While that's certainly true, it misses a couple of key points. First, if you checked the price on your bond each day, you'd see that it goes up and down with changes in the bond market, too. If you hold a well-run bond fund over a similar period, you won't likely lose principal. Second, inflation can eat away at the real value of your bond, whereas a mutual fund will recoup some losses by investing money from maturing bonds and income payments into bonds paying higher yields.

Some innovative new funds aim to capture some of the appeal of the hand-built bond ladder while keeping all the pluses of bond mutual funds. Although they are brand-new, they come from some of the best bond managers around. In addition, you can hop on or off at any time just as with any other mutual fund.

One could argue that the pioneer in all this was American Century, which launched Zero Coupon bond funds designed to act like zero-coupon Treasuries. There's limited appeal to those funds, though, as it is hard to justify the added expenses when an investor could simply buy a zero-coupon Treasury himself. After all, there's no credit research or call research needed. In fact, the funds have had a hard time keeping pace with their Treasury STRIPS benchmarks.

Fidelity Defined-Maturity Funds
Fidelity aims to help you build a better bond ladder with four defined-maturity muni-bond funds it launched last Wednesday.

The funds will target 2015, 2017, 2019, and 2021 as maturity dates: Fidelity Municipal Income 2015 (FMLCX), Fidelity Municipal Income 2017 (FMIFX), Fidelity Municipal Income 2019 (FMCFX), and Fidelity Municipal Income 2021 (FOCFX). Soon after the dates of maturity (each on June 30), the funds will be liquidated, and any remaining value returned to shareholders. The funds' aim is to produce as high an income stream as possible up until the maturity date while still maintaining principal. Thus, you can dial in the right maturities for your needs.

Holding the funds to maturity won't guarantee you'll get back the exact net asset value you paid. However, because the bonds are maturing around that date, the funds will become less volatile so that you will have a pretty dependable account value and less instability at the liquidation date than you would have if you bought a long-term muni fund and then sold in 10 years.

The funds will charge an expense ratio of 0.40% and be managed by Mark Sommer, Jamie Pagliocco, and Kevin Ramundo. That's a pretty appealing combination: low costs and strong management.

IShares Defined-Maturity Muni Funds
While Fidelity was the first to do this in open-end format, iShares already has funds like this in exchange-traded fund format. The funds target each year from 2012 to 2017. For example, iShares 2012 S&P AMT-Free Municipal Securities (MUAA) will provide income up to the Aug. 31, 2012, maturity date, and then it will liquidate and return money to shareholders.

Unlike the Fidelity funds, the iShares funds are passively managed index funds that will seek to match their index's returns by creating a portfolio similar to that of their index. Matching an index security by security isn't practical in the muni space because of the limited liquidity in munis. Thus, the iShares funds are trailblazers both for their target maturity and for their passive approach to municipal management. It will be interesting to see how they work out. They are run by BlackRock and charge 0.30%.

PIMCO's Inflation-Protected Ladder
While a muni-bond fund would see a boost in yield should inflation rise, shareholders would still suffer a trim in spending power. Enter the eggheads at PIMCO. They've come up with some bold new funds that deliver dependable inflation-adjusted income so that your purchasing power is protected.

PIMCO buys Treasury Inflation-Protected Securities of a variety of maturities so that you're getting an even exposure across the maturity spectrum. However, there aren't TIPS maturing in every month, so PIMCO created baskets of TIPS that act like TIPS maturing in the times when there are gaps. It's an intriguing focus on monthly income from a firm that has long championed a total return approach. PIMCO has applied for a patent on this process. If it gets it, there might not be many imitators. Unlike the muni funds I mentioned, PIMCO's goal would be to whittle principal down to nothing by the maturity date so as to maximize payouts along the way, which should also grow over time. Thus, this means the PIMCO funds would have higher payout since they are not going to have principal left at the end. So, these funds give you a very different experience than the target-maturity munis above.

One way to think of this type of fund is as a cousin to an annuity that is best suited for retirees. Each day PIMCO updates the real distribution rate for PIMCO Real Income 2019 (PRIFX) and for PIMCO Real Income 2029 (PRIIX). You can find it here on the Performance tab. The current rate for 2019 is 11.63%. For the year 2029, it is 5.68%. Those figures tell you about what payment rate to expect to maturity if you were to buy on that day. You can turn that into dollar terms by multiplying the amount of your planned investment.

Launched in the fourth quarter of 2009, the funds are still small and expenses are not cheap. The retail D shares cost 0.79%, and the institutional shares charge a more modest 0.39%. At fund supermarkets, the institutional shares can be tapped for a $100,000 minimum and a $75 fee. The D shares have a $2,500 minimum and no fee.

The funds just got a new manager, Rahul Seksaria. Given the formulaic nature of the strategy, though, I wouldn't expect the manager to have a lot of sway over how these are managed.

Tax Angles
The strategies and people behind these funds make them worth a good look. Be sure to consider your tax situation before you buy, though. The muni funds are most useful if you figure to be in a relatively high tax bracket along the way to maturity.

The PIMCO funds, on the other hand, will throw off taxable income that will be more appealing if you expect to move into lower tax brackets in retirement or are investing in an IRA or other tax-sheltered account.

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Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.