Kinnel's Favorite Short-Term Bond Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar. As markets have turned volatile, many investors have looked to shore up the safe portions of their portfolios. Joining me to share some favorite short-term bond fund picks is Russ Kinnel. He's Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's just start by talking about the role that short-term bonds or short-term bond funds might play in a portfolio. How would I use them? And how would I think about right-sizing that position?

Kinnel: I think short-term bond funds are very useful, even if unexciting, because they can take that step as the next line of defense after your money market fund. They're going to have a little more yield and a little more return. But also a little downside, a good short-term fund with high credit might lose 30 or 40 basis points in a down year, at least that's the history. So, there's a bit of a risk involved, but not a lot and a little more upside. So, I think it's a really useful thing. You can use it as your next line of defense. If you have say, some upcoming expenses--you're going to buy a car, you've got kids' tuition bills, anything like that--I think it's a really good place to invest. So, I think it's a pretty useful tool for just about any portfolio.

Benz: You definitely don't want to think of short-term bonds, though as kind of a tactical parking place. If you are worried about equity market volatility, you shouldn't be flipping things around based on short-term market action, right?

Kinnel: No, please don't do that. So, market-timing is a very hard thing to do, and I wouldn't recommend that.

Benz: So, let's get into some of the funds that you really like in the short-term space. Let's start with a very safe, short-term fund. Vanguard Short-Term Federal. I'm guessing low costs would be part of the appeal here.

Kinnel: Yes, low costs, almost no risk. So very--it's the next step out for money market in terms of duration. It's all as the name implies, it's all federal government, mostly mortgages and Treasuries, so, high quality. It'll get you a little more yield than a money market. But again, that's just very much at the most conservative end, if that's what you really need.

Benz: Let's take a look at a broader short-term bond fund. This is Fidelity Short-Term Bond. Let's talk about it, and its overall complexion takes a little bit more credit risk, but generally a pretty guarded profile here, too.

Kinnel: That's right. So, besides mortgages and Treasuries, now you've also got a lot of high-quality investment-grade corporate bonds. So, now you still have almost all the assets are in AA and AAA. But again, with corporate debt, you've got some more risks. This is a fund that had some issues in '07 and early '08, and they kind of got religion about really being more disciplined about staying dedicated to high quality, and they've been a very steady fund ever since.

Benz: So it's been a pretty risk-conscious option. How about for investors who are looking for a little bit of inflation protection along with their short-term fund? One fund that you and the team like is Vanguard Short-Term Inflation Protected Index. Let's talk about that.

Kinnel: This is a really great fund, we rate it Gold, super cheap. But as you mentioned, it's a nice inflation protector, because TIPS give you inflation protection, but because it's short-term, it also doesn't give you that interest-rate risk that regular TIPS funds do have. So, you're even less risky than a regular TIPS fund. Footnote on that is, TIPS funds really mostly belong in a tax-sheltered account because of the way the taxes are figured for TIPS funds. So probably a good fund for like retirees, IRA, or something like that, where if you're fairly bond-heavy portfolio, you might want a little more inflation protection.

Benz: Great point, Russ. Speaking of taxes for investors, taxable accounts, you have another idea that's T. Rowe Price Tax Free Short Intermediate. This is a municipal bond fund. So, let's talk about, first, who should look at municipal bonds, and then get into the specific attractions of this fund.

Kinnel: Sure. Obviously, people with higher--in the higher tax brackets--are most likely to benefit from muni funds. It's worth running your own situation through one of the muni calculators that are out there. But if it works for you, and I think munis also provide a little nice diversification, munis are very rare to default. So, a fund like this, I think is a really nice diversifier. It's short intermediate, so it's got a little more interest-rate risk. It's got a little more credit risk, and then it's got some meaningful exposure to AAA, B, and A, but we really like T. Rowe; we think they've done a great job here. We did downgrade the fund from Gold to Silver, not because of concerns about management or strategy, but just because fees have remained kind of high while others have gotten cheaper. So, it's kind of only an average fee. But otherwise, we really like the fund. I think it's a really nice way to get some muni exposure without a lot of risk.

Benz: Russ always great to get your perspective. I know our viewers love to hear your picks. Thank you so much for being here.

Kinnel: You're welcome.

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