4 Bond Funds for Risk-Averse Investors

Note: This article is part of Morningstar's May 2016 Risk Management Boot Camp special report.

High-quality bond funds. It's hard to get overly excited when the topic comes up. Bond yields have been so low for the past few years that it has given way to debate about what purpose they should serve in a portfolio: whether they are for income, or simply for diversification of equity risk and downside protection in one's portfolio.

As discussed by Morningstar senior analyst Cara Esser in her recent article "The Case for Core Bond Funds," for retired investors--especially those taking distributions from their portfolios to fund annual expenses--bonds (and bond mutual funds) still play a crucial role in diversification and downside protection. And for many retirees, sometimes "boring is best"--in other words, a more plain vanilla, diversified bond fund with minimal credit risk and moderate interest-rate risk that will act as a true diversifier to equities in a portfolio is likely the most suitable choice for a retired investor who has a moderate time horizon and is making annual withdrawals from his portfolio, Esser said.

To help identify some funds that are good candidates for lower-risk core bond holdings, I looked at the funds in the intermediate-term bond Morningstar Category that earn Gold, Silver, or Bronze Medalist Ratings.

Funds in the intermediate-term category tend to invest in a mix of corporates, mortgages, and Treasuries, and they often benchmark themselves against the Barclays U.S. Aggregate Index. In terms of interest-rate risk (as measured by duration) most of the funds in the intermediate-term bond category are pretty similar to the Aggregate Index's 5.5 years, though as Morningstar director of fixed income Sarah Bush points out, duration risk can be a bit lower for funds with more high yield/credit risk, and vice versa.

Some of the datapoints I used in my screens for equity funds and international-stock funds, such as standard deviation, downside capture ratio, and Morningstar Risk, work better to sniff out funds that take on interest-rate risk, but they can be less useful when trying to get your arms around a fund's credit risk. To weed out funds that take on a lot of lower-quality credit risk, I zeroed in on medalist funds with lower levels of below-investment grade debt (less than 10%).

Finally, especially since high-quality bond funds' returns have been so meager lately, I looked for funds with low fees relative to their peer group. Here are some funds that made the cut.

Baird Aggregate Bond

BAGIX

Morningstar Analyst Rating: Silver Fee Level: Low

This fund's consistent and risk-conscious process emphasizes high-quality credit: The fund tends to have a higher allocation to A and BBB rated securities and a lower allocation to noninvestment-grade or nonrated securities than its average category peer, says Morningstar analyst Emory Zink. Like many funds in the intermediate-term bond category, this fund keeps its duration neutral to the Barclays U.S. Aggregate Bond Index, (as does its sibling fund

Fidelity Intermediate Bond

FTHRX

Morningstar Analyst Rating: Silver Fee Level: Low

The fund has a restrained risk profile compared with its intermediate-term bond category peers, says Zink. It tends to court less interest-rate risk: Its managers keep the fund's duration in line with that of the Barclays Intermediate Government/Credit Index, so its duration (currently 3.9 years) is shorter than many other funds in the category that eye the Barclays U.S. Aggregate Bond Index's 5.5 years as a target. The managers focus on identifying pockets of relative value in certain sectors, individual names, and segments of the yield curve, says Zink. The corporate exposure includes a sizable stake in BBB rated bonds (20%) but, unlike many competitors who will hold sizable stakes in high yield, this fund is limited to 5% in below-investment-grade debt. Though the fund's 4.3% return per year over 10 years lags 67% of category peers (many of whom have longer duration and have benefited from high-yield strength in recent years), compared with peers of similar short duration and with the Barclays Intermediate Government/Credit Index, the fund's returns are solid, says Zink.

Vanguard Total Bond Market Index

VBTLX

Morningstar Analyst Rating: Silver Fee Level: Low

The fund attempts to replicate the performance of the Barclays Capital U.S. Aggregate Float Adjusted Index, a broad proxy for the investment-grade U.S. bond market that includes investment-grade corporate, government, and agency debt but excludes agency and mortgage-backed securities held by the Federal Reserve. Because of the fund's relatively higher exposure to government bonds, it tends to outperform when credit spreads widen, which often occurs during times of market stress. During 2008, the fund's hefty stake in high-quality bonds helped it gain 5.2%, topping more than 90% of its peers. When spreads tighten, however, the fund will lag its category: 2009, when the fund fell into the category's lowest decile, is a case in point. Over the 10-year period, the fund's 4.9% return is in line with the Barclay's US Aggregate Bond's but edges past its typical intermediate-term peer by more than 30 basis points per year--thanks in no small part to its rock-bottom 6-basis-point expense ratio.

American Century Diversified Bond

ACBPX

Morningstar Analyst Rating: Bronze Fee Level: Low

This fund's managers typically hew close to the Barclays U.S. Aggregate Bond Index, making adjustments to the portfolio only when they finds valuations compelling, says Morningstar analyst Gretchen Rupp. The resulting portfolio carries less credit risk than most of its intermediate-term bond category peers--as of March 31, 66% of the portfolio is in AAA rated debt. A relatively high-quality bent has helped the fund hold up during credit sell-offs in the past better than rivals--for example, its return was fourth in its category in 2008. But the flipside is also true: The fund will lag in markets that reward credit risk, such as 2009, when it finished behind 82% of peers. Over the long term, the fund's steady, conservative approach has paid off: Its 5.3% return over 10 years beats the Agg's return by 36 basis points and lands in the top quartile of its intermediate-term bond category.