Top Bond-Fund Picks for Retirees

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Although interest-rate worries roiled the bond market in 2013, bonds are still a key component of many retirees' portfolios. Joining me to share some of his top fund picks is Eric Jacobson. He is a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: It's good to see you, Christine. Thank you.

Benz: Eric, we did a similar video like this a couple of years ago. It was very much a favorite of some of our readers and users of Morningstar.com. So I thought we'd cycle back through in light of these headwinds that seem to be facing the fixed-income market right now.

I'd like you to share some of your top ideas for retiree portfolios, and I'd like to start with what you think of as good core anchor funds for retirees. And maybe we'd want to think about funds where people have, say, a five-year time horizon or thereabouts. What types of fund should they be looking at if that is their time horizon?

Jacobson: Let me talk a little bit in terms that are a little more common among institutions; pretty simple though. Generally, we talk about them in terms of being either core or core-plus.

Core is funds that attract the Barclays Aggregate Bond Index, which is sort of, as you know, the S&P 500 of the bond market. It's very high quality; it's focused a lot on government bonds, mortgages, and high-quality corporates.

Core funds pretty much tend to stick almost exclusively with those sectors. They usually have a duration-management policy that keeps their interest-rate sensitivity kind of close to the core. And even if they might branch out a tiny bit, they very rarely take on much extra risk outside of the index.

The core-plus-type funds often have the ability to have maybe 10% or 15% in high yield, maybe some emerging markets, a little bit more non-U.S.-dollar underlying bonds, and then things like non-agency mortgages, asset-backeds, and commercial mortgage-backeds. Some of those are higher-quality things but not well represented in the index.

I differentiate between the two in terms of portfolio construction by thinking, if I really want to do some of my own work selecting funds in general, maybe then you want to start with the real core fund that doesn't branch out that much, use that as your anchor, and then build other funds around it, whether they'd be high-yield, emerging markets, et cetera. That way you not only do get to choose the sectors and the exposures but you get to pick managers that you like, rather than relying on your core manager to pick from all those sectors.

On the other hand, if you want to maybe have a little bit more inclusive fund and want to give a manager the ability to branch out a little more, especially, if he or she thinks that there's some value to be had in some of those areas, then you want to maybe look at a core-plus fund.

The biggest, baddest one that everybody knows about is PIMCO Total Return. Manager Bill Gross does that kind of thing in that fund. He also manages, as you know, Harbor Bond and Managers PIMCO Bond, both of which pursue almost exactly the same strategy. The portfolios aren't always identical, but pretty much have the same strategy. Those two funds are no-load and cheaper, as you know.

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Benz: Those are core-plus funds?

Jacobson: Exactly.

Benz: Are there any other in that core-plus all-in-one realm that you would recommend that investors check out?

Jacobson: Sure. There are a few of them that we perennially like: Metropolitan West Total Return, Dodge & Cox Income. One of the ones that we haven't talked about as much recently but we like a lot is Loomis Sayles Core Plus Bond.

Let me just go back real quickly for one second and mention, if you really want to focus on that core area, though, then I would suggest a fund, for example, like JPMorgan Core Bond, or even if you're an index lover, Vanguard Total Bond Market Index. I like actively managed bond funds because I do think managers can add value, but if you're an index lover that's the fund to go with.

Benz: And it's certainly nice and cheap.

Jacobson: Yes.

Benz: Let's look at funds for that short-term slot in investors' portfolios. We've covered the core, maybe where you've got a slightly longer holding period. But let's talk about money that maybe is a step beyond money market funds, but money that you expect to tap within the next couple of years. What's a good starting point for retirees when they're thinking about that slot in their portfolios; they're not satisfied with what cash yields are and maybe want to earn a little bit more but don't want to take on much more risk?

Jacobson: I think one of the most important things to look at is what's in those portfolios, and I say that because, history is such that a lot of firms have sold funds in the shorter space and tried to compete based on how much income they generate or their returns by picking up riskier things. And I don't know want to say hiding them in there, but not really talking a lot about how much riskier their portfolios are than some competitors who are a little bit more plain vanilla.

You really just want to make sure that if that's the area you're going for, and in your mind short means lower risk, then check out the portfolio, make sure there's not a lot of high yield, much lower-rated stuff, sectors that you're not familiar with, et cetera.

Benz: And if yield is a big outlier relative to the categories, that should be your signal to get in there and make sure you really understand the strategy and understand the risks that are embedded in the fund?

Jacobson: Exactly. If that fund yields a lot more than its competitors, there's got to be a reason for it. There's no free lunch.

Benz: I know that another PIMCO fund taps your list here in terms of good, short-term funds, that's PIMCO Low Duration.

Jacobson: That's right. It's run by Bill Gross with lot of assistance from the short-term desk at PIMCO, run by a fellow by the name of Jerome Schneider. He's done a really good job ever since replacing Paul McCulley, a big name at PIMCO. That's another fund that we like for pretty active management but also not taking on a ton of risk.

Benz: Well, here again, are there no-load analogs for people who want that particular strategy, but want to buy it themselves and aren't using an advisor?

Jacobson: Sure. We like a few of them. T. Rowe Price Short-Term Bond is one of them. We also like Fidelity Short-Term and, of course, Vanguard does some of their own stuff there, too. Again, the thesis there, more than anything, being it's cheap and Vanguard Short-Term Investment-Grade would be one of the options there.

Benz: One follow-up question on this whole short-term idea. A lot of investors who maybe are looking at some of these short-term funds are saying, "Why do I need this interest-rate sensitivity, even a little bit of it, for what is barely a higher yield than I am getting on cash?" What do you say to people who are in that mind-set?

Jacobson: A couple of things. One, is that you want to get a sense of where that range is. The yield curve, in other words, the extra income that you get for going out a little bit longer on the maturity spectrum, is normally such that it is rewarding enough to take a little bit more interest-rate risk. But I don't want to tell people not to buy certificates of deposit or other options like that. Mutual funds are not the only game in town. Sometimes, as you know better than I do, there are opportunities and things like CDs and so forth where you can make a little more.

But, in general, I want to just caution people that we don't know if or when bond yields across the board are going to start rising even more than they already did last summer. We waited several years for the summer sell-off to come. It was one of the first big interest-rate spikes that we've had in quite a while. If the economy starts doing really, really well, of course, that's a different issue. But if we keep muddling along the way we are, there's no reason that they have to spike up that much more.

I would also mention that the expectations for very short-term interest rates, the rates that the Federal Reserve sets, are still pretty stable for quite a while. I took a look at where federal-funds rate futures are trading before we came in here, and the market is not even giving it a 50-50 probability for a rate hike until April 2015. It doesn't even get into the higher numbers until later in 2015, and that's just where we stand today.

Benz: Switching gears a little bit, I'd like to talk about more aggressive picks. Maybe where people have a slightly longer time horizon, something like five or 10 years, or even longer; some of the funds that you think are good, aggressive kickers once you've covered your basis on those intermediate and short-term picks. Let's talk about some ideas in that realm?

Jacobson: The sectors that we're talking about very often are multisector funds that spread it around maybe among emerging markets, non-U.S., high yield, et cetera, and certainly funds in those individual sectors, as well.

One of the multisector funds that we like quite well was just named Manager of the Year, PIMCO Income. I don't want to oversell how aggressive it is. The fund has a very good record of being very resilient in tough times. But it does take risk on more risk than your core kind of funds. It holds a lot of assets at this time in nonagency residential mortgage bonds and balances that out with some interest rate sensitivity from the Treasury market and so forth. And it's got a few other things mixed in there, high-yield, emerging markets, et cetera, but it's been very, very well managed.

Benz: Eric, I know there is a Fidelity fund that you like as well for this aggressive slot in retired investors' portfolios.

Jacobson: Right. One of them is Fidelity Strategic Income. That's more of the multisector style; it has assets in a variety of different things that balance it out among different risks sectors. If you're looking for a high-yield fund to fill that slot, Fidelity High Income is one that we like quite well also.

Benz: And there's a BlackRock fund that you like in that high-yield space?

Jacobson: That's right. It's a BlackRock High Yield, and this is a fund that's done really well over the last several years. I think BlackRock has been building that business ,and it's an interesting fund, as well. A fellow by name of James Keenan runs it.

Benz: How about Hotchkis & Wiley; that's a name that may not be as familiar to retail investors, but you have a fund there that does fit that aggressive slot, as well?

Jacobson: Yes, and that fund is run by a couple of guys named Ray Kennedy and Mark Hudoff; they're both veterans of PIMCO. They went out, left PIMCO, and set up their own fund at Hotchkis & Wiley. It's on the small side; they're still sort of building resources there. They use a lot of analysts from the equity side of the shop, but they do have some of their own folks now. They've had a little rough time out of the gate, but for the most part, they're doing pretty well. And that's a pretty attractive fund.

Benz: That's Hotchkis & Wiley High Yield?

Jacobson: Exactly.

Benz: Eric, I'd like to talk a little bit about municipal bonds; it's been a deeply unloved sector over the past year, maybe for good reason. But I'd like to talk about funds for people who are in those higher tax brackets that you like a lot. I know Fidelity always tops your list when we're talking muni funds; let's talk about some specific funds that you like from Fidelity.

Jacobson: I also want to caution people: When you look at the records of some of these funds, they aren't all terrific. Fidelity did really, really well during 2008. They've had a very consistent style since then. They haven't knocked the lights out in terms of performance. But as you say, for a long-term holding with a team that really knows what they're doing and you can trust, we really still like them.

Fidelity Municipal Income is one, and sort of the sister fund to that is Fidelity Tax-Free. Fidelity Municipal Income may hold some bonds subject to the alternative minimum tax. For folks [in which the AMT] doesn't really matter, [Fidelity Municipal Income is] a good choice. If you really want to make sure you avoid the AMT, then you want to go with the Fidelity Tax-Free fund.

Benz: Those two funds are both longer-maturity funds. There's also a Fidelity fund that sticks with intermediate-term bonds. Let's talk about that muni fund.

Jacobson: That's Fidelity Intermediate Municipal Income, and that's really the main issue, is that you get all the same skill and strategy that you do with the rest of the Fidelity muni team, but it's going to be benchmarked a little bit more toward the intermediate part of the maturity spectrum.

Benz: Moving beyond Fidelity, there are a couple of other funds and shops that you like. DWS is one for people who work with a financial advisor; there's a muni fund that you like quite a bit from that group.

Jacobson: Right. DWS Managed Municipal Bonds. Phil Condon is the lead manager. He's got a good crew there that he's been working with for years and years. He, too, did pretty well around the time of the financial crisis and bounced back well. He's just a good solid manager, he's been doing it for a long time. That's an attractive fund.

Benz: And [you have a] T. Rowe Price fund, as well?

Jacobson: That's right. T. Rowe Price Summit Municipal Intermediate. Another one, again, with intermediate maturities and the same kind of research process that you get with everything else at T. Rowe Price, such as modest cost, et cetera. It's another fund that we like quite well.

Benz: Eric, thank you so much for being here to share all these picks. People love to hear specific fund ideas, and you've given them a wealth of different ideas and ways to think about their bond portfolios.

Jacobson: It's my pleasure, Christine, thank you.

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