Standout Taxable-Bond Funds

This article is part of Morningstar's Guide to Dividend and Income Investing special report. A version of this article appeared in November 2015.

Knowing you need bond funds in your income arsenal is one thing; knowing what kind of bond funds you need is another.

The "right" type of bond fund or funds for you comes down to personal preferences. Do you want to stick with the highest-quality bonds you can find, or are you willing to delve into lower-quality bonds in exchange for higher yield? Will you forgo the incremental yield and diversification benefits that high-quality long-term bond funds offer for some protection against rising interest rates? Will you dabble in world bonds for yield pickup--and if yes, do you want currencies in the mix?

Once you have a sense of what you're looking for--and if you already have a bond portfolio, what you may be missing--limit your fund search to the groups that meet your criteria. Morningstar has sliced and diced the bond-fund landscape into a handful of manageable asset classes, listed below. Within each, we list some of Morningstar's favorite funds to get you started.

Domestic Taxable-Bond Funds Funds landing in the long-term, intermediate-term, short-term, and ultrashort bond Morningstar categories cluster here. The funds blend government bonds, asset-backed or mortgage-backed securities, investment-grade and high-yield debt, and a modest dose of foreign bonds. Although some offerings are more income-oriented or more opportunistic than others, most provide decent exposure to a variety of bond types.

Three of Morningstar's favorites in this crowd are

"An experienced team, a thoughtful long-term approach to investing, and an attractive price tag support Dodge & Cox Income's Morningstar Analyst Rating of Gold," says Morningstar director of fixed-income strategies Sarah Bush. The managers invest with a three- to five-year time horizon, seeking to outperform the Bloomberg Barclays U.S. Aggregate Bond Index while minimizing the risk of loss. Turnover is low, yield generally exceeds those of its peers and benchmark, and duration tends to be shorter than the index.

Meanwhile, Fidelity Total Bond earns its Gold rating due to its low fees, deep resources, and consistently strong risk-adjusted returns. The managers don't make significant duration bets, but they do make active sector bets--usually contrarian in nature. As such, the fund can carry larger weightings in lower-quality and emerging-markets bonds than other funds in its category. Nevertheless, it has delivered over the long term.

Like Fidelity, Western Asset Core Bond is managed by one of the best bond shops around, supported by a large and diverse team. Management blends a macro outlook with individual security selection based on fundamental research. They'll go beyond the securities that populate their benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index. Senior analyst Maciej Kowara notes in his latest analysis, "It is hard to find a serious weakness" in the fund.

Premium Members can access a complete list of Morningstar Medalist funds in this category

.

Silver-rated

For those seeking broader bond-market exposure via an ETF, Silver-rated

Flexible Bond Funds The multisector and nontraditional-bond fund set lands here. Like domestic taxable-bond funds, flexible bond funds can invest across a mix of bond types. Unlike domestic taxable-bond funds, flexible bond funds invest more aggressively in lower-quality paper and/or international debt. And nontraditional-bond funds, in particular, enjoy a high degree of interest-rate flexibility and may employ shorting. Simply put, these are the least-constrained bond funds.

The only mutual fund in this group to earn a Morningstar Analyst Rating of Gold is

Premium Members can access a complete list of Morningstar Medalist funds in this group

.

Government-Bond Funds The highest-quality taxable-bond funds reside in this group. To be included in one of Morningstar's U.S. government-bond categories, a fund must keep at least 90% of its assets tucked in government securities. Funds that invest strictly in Treasuries, strictly in mortgage-backed securities, or in some combination of the two populate the group. There are three government-focused Morningstar categories included here, broken down by duration: short government, intermediate government, and long government.

Among this group, favorites include

Fidelity GNMA recently lost longtime manager Bill Irving, but Bush notes that the team he leaves behind is strong, and the strategy remains the same. The team invests at least 90% of assets in Ginne Mae MBS, with the remainder tucked in other issues backed by the full faith and credit of the U.S. government; they eschew interest-rate bets. Long-term results are strong, and a reasonable expense ratio helps, too.

Meanwhile, Vanguard GNMA's expense ratio isn't just reasonable; it's Admiral shares charge just 0.11%, which is one of the cheapest expense hurdles in the intermediate-term government-bond category. Manager Michael Garrett, of subadvisor Wellington Management, keeps things simple, with a portfolio largely comprised of Ginnie Mae mortgage pass-throughs. Thoughtful positioning and that low expense ratio have allowed the fund to shine relative to its peers over the long term.

Premium Members can access a complete list of Morningstar Medalist funds in this group

.

Corporate-Credit Funds These funds favor bonds issued by corporations. Morningstar categories in this group include corporate-bond funds, high-yield bond funds, and bank-loan funds. Corporate-bond funds focus on bonds rated investment-grade; these funds, therefore, exhibit some degree of interest-rate sensitivity. High-yield bond funds target bonds rated below investment-grade; these funds invite more credit risk than interest-rate risk. Finally, bank-loan funds also invest in securities rated below investment-grade, and their interest payments are periodically reset. Due to their floating rates, bank loans theoretically have limited sensitivity to interest-rate movements.

A favorite here is the currently closed

Other highly rated funds that are open to new investors in this group include Silver-rated

Premium Members can access a complete list of Morningstar Medalist funds in this group

.

On the ETF front,

World and Emerging-Markets Bond Funds The funds in this group home in on fixed-income securities issued by governments and corporations outside of the United States. That's about the only thing they all have in common. World-bond funds, in particular, must invest at minimum 40% of their assets in non-U.S. debt, but some exclude U.S. debt entirely, or focus on corporates rather than governments, or hedge currencies--or don't. Emerging-markets debt funds, meanwhile, keep at least 65% of their assets in developing-markets debt; but here, too, there are significant variations in currency strategies.

Premium Members can access a complete list of Morningstar Medalist funds in this group

.

Inflation-Protected Bond Funds As their names suggest, inflation-protected bond funds seek to protect investors from rising inflation. As such, these funds invest in securities whose principal values adjust along with the rate of inflation. However, these funds aren't impervious to changes in interest rates: They will likely suffer if rates rise for a reason other than rising inflation.

Morningstar's favorites here are Gold-rated

The latter fund, meanwhile, focuses on shorter-duration fare. "The fund's short duration reduces interest-rate risk and provides a high correlation to immediate inflation but leads to a lower yield and return than most of its peers," says Yoo. The fund has done an excellent job of tracking its index over time, and carries a modest 0.07% expense ratio. It's also available as an ETF with the ticker VTIP.

Premium Members can access a complete list of Morningstar Medalist funds in this group

.