Fixed-income investors should consider playing defense because of potential credit problems or a spike in rates, but there's a risk of being too conservative, as well, says Morningstar's Russ Kinnel.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Bond funds have had a great year so far in 2014, but many investors are still feeling quite nervous about bonds. Joining me to discuss some good conservative bond funds is Russ Kinnel; he is director of manager research for Morningstar.
Russ, thank you for being here.
Russ Kinnel: Good to be here.
Benz: Russ, let's talk about the case for being a little bit conservative with at least part of your bond portfolio. Why would one want to think about being risk-averse particularly right now?
Kinnel: I think there is certainly the danger of another interest-rate spike or credit issues where we'd see some problems with credit quality. So, I think, as you say, you don't necessarily want your whole portfolio to be conservative, but I think it makes sense to play defense. The bond market is not giving you a ton of yield right now, so at least dial down the risk side of the equation.
Benz: One comment I would make is that people were saying, "You need to be really defensive on bonds" even three years ago, and it hasn't been a terrible period for bonds. There have been ups and downs. Certainly last summer was a difficult time for anything with duration in it, but, overall, bonds haven't performed abysmally. Is there a risk to being too conservative?
Kinnel: There definitely is a risk of being too conservative. You need to keep up with inflation, and a conservative bond fund might do that and might even outperform somewhat. But you don't want to just have all your eggs in one basket, and as you imply it's hard to time the market.
I wouldn't suggest these are market timers. I'm not suggesting that interest rates are going to spike up tomorrow. That's really too difficult to call. I think it's more a case of rounding out your portfolio with some conservative investments. I think cash isn't paying you anything. Here are some funds that can lose some money, but they're so conservative they probably won't lose a lot. So it's a nice thing to have as your first step above cash.
Benz: Let's discuss the first of the two that you want to talk about, that's FPA New Income. Let's discuss this fund's mandate, which I think is little interesting and perhaps sets it apart from other bond funds.
Kinnel: That's right. It's not just looking at a straight bond index but also wants to beat inflation by 100 basis points. And it's really kind of an absolute return view. The fund was formerly run by Bob Rodriguez and now Tom Atteberry, though Rodriguez is still in the background there, and they really focus on protecting against losses, and so over the years the fund has become quite conservative. It doesn't want to take on a lot of interest-rate or credit risk. It's really focused on that preservation of capital.
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Benz: And how has it done versus that mandate? Has it delivered on its promise?
Kinnel: It's done very well. I wouldn't expect it to run in a rally. So if it's a good time to own lower-quality credit or if interest rates come down a lot, this fund is going to be toward the back, but when we have problems in the bond market, this fund has consistently done well.
So I think it's really dependable on that front. In theory, they could take on more credit and interest-rate risk. Right now they have very little interest-rate risk and a small amount of credit. They've got some mortgages, some of which are not government mortgages, but still it's pretty conservative.
Benz: And given that long-duration bonds and lower-quality bonds have had quite a run, it may not be a bad time to think about something like this.
Kinnel: That's right. It's a contrarian-minded fund, and this is probably a good time to be contrarian. FPA went no-load with their funds about a year or two ago. So a lot of people may not have looked at this fund before, but I think it's worth a good look.
Benz: The other pick you brought is a Vanguard fund. It's one for people who are concerned about limiting taxes as well as who are looking for a good-quality short-term bond fund. Let's talk about that particular fund.
Kinnel: I like Vanguard Short-Term Tax-Exempt just because it's a nice conservative fund even compared with other short-term municipal-bond funds. It's on the cautious end, which means that its long-term returns are not that great-looking, but it's much less risky.
Again just out a little bit from cash, you're taking some risk, you can lose money particularly in the short-term. But it's got very low credit risk, very low interest-rate risk, and therefore, a nice vehicle. And as you say it's tax-exempt. So the yields are actually a little better than they seem when you factor in taxes.
Benz: So it's not an index fund, but it's a very well-diversified portfolio?
Kinnel: That's right. It's not an index fund. Indexing munis is really hard, so what Vanguard does instead is they come up with funds that are very close to index funds and munis. They have very low-cost, very diffuse portfolios, and they tend to run low-risk, in part, because their fees are so low that they can produce a yield that's competitive with other funds, yet take on less risk to do it.
Benz: Russ,thank you so much for being here to share this picks.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christian Benz for Morningstar.com.
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