These Core Bond Funds Aren't Taking Any Chances With Credit Quality

Many bond investors, both professional and individuals, have fled interest-rate risk over the past several years, concerned about what rising bond yields--if and when they materialize--could mean for the prices of longer-dated bonds.

In exchange, they've viewed venturing into lower-rated credits as a more reasonable way to boost their yields. Not only have high-yield bonds seen significant asset inflows for the year to date, but many intermediate-term bond funds have also been venturing down the credit-quality ladder. Of the 211 intermediate-term bond funds with average credit qualities in Morningstar's database, 87 recently had average credit qualities of BBB, and another 37 had average credit qualities of BB or below. There has been a similar phenomenon going on with short-term bond funds. Among the 111 offerings with data on average credit quality, 42 had average credit qualities of BBB and another 16 had average credit qualities of BB or lower.

That shouldn't automatically set off alarm bells. For one thing, BBB is an investment-grade rating--the lowest rung of investment-grade, but not junk. (Bonds with BB ratings and below, by contrast, are considered junk.) It's also worth noting that Morningstar's "average credit quality" ratings aren't a simple average; rather, lower-quality bonds are given a heavier weighting in the fund's average-credit-quality assignment, as discussed here.

Moreover, the economy has been improving and corporate-bond defaults are at a low ebb, so it's no wonder that so many bond-fund managers have dipped down the credit-quality ladder as a means of boosting their portfolios' yields. (Balanced-fund managers are doing it, too, as discussed in this article.) Indeed, some of the short- and intermediate-term bond funds with lower average credit ratings are run by highly regarded, highly experienced managers. The Gold-rated

That said, it stands to reason that portfolios that are heavy on lower-quality bonds--especially those with heavy allocations to true junk bonds--might not provide the ballast investors are looking for in an equity-market shock. And given how low yields are on lower-rated credits in absolute terms, they might not hold up all that well if rising rates materialize, either, as discussed in this article.

Morningstar has three whole categories (short-, intermediate-, and long-term) devoted to government-bond funds with pristine credit qualities, but funds in those groups are apt to be too narrowly focused for investors seeking diversified bond exposure. In search of topnotch bond funds that take limited credit risk but don't confine themselves to U.S. government debt, we used our

to search for Morningstar Medalists in the intermediate- and short-term bond categories that have average credit qualities of A or higher. Premium Members can click

to view the screen's output and tweak it to fit their own specifications.

Of course, these funds may not perform well in every market environment; some of them may fare poorly in a rising-rate environment, for example, and their portfolios won't always remain high quality. (

Here's a closer look at three of the funds that made the cut.

Category: Intermediate-Term Bond | Analyst Rating: Gold | Average Credit Quality: A

This stalwart has not historically been shy about dipping down into lower-quality corporate bonds, so its inclusion on this list may seem a little surprising at first blush. But the fund's stake in below-investment-grade bonds was limited as of its most recently available portfolio (5% of assets in BB bonds and nothing in bonds rated B or below). Management also counterbalances the risks of lower-rated bonds by holding a heavy allocation to U.S.-government-backed agency mortgage bonds, boosting the portfolio's average credit quality. The fund has historically maintained muted interest-rate sensitivity, too. Morningstar analysts have long been fans of the research interplay between Dodge & Cox's equity and fixed-income analysts, and the firm's management team is highly experienced. Superior stewardship and low costs are additional points in its favor.

Category: Intermediate-Term Bond | Analyst Rating: Silver | Average Credit Quality: A

In contrast with peers that court more interest-rate sensitivity or credit risk, this fund shies away from both types of yield-seeking. Analyst Vishal Mansukhani notes that lead manager Robin Foley and comanager Rob Galusza keep duration in line with the Barclays Intermediate Government/Credit Index, which is shorter than the typical intermediate-term fund, and they also steer clear of below-investment-grade debt (bonds rated BB and below). Not surprisingly, the fund's 1.7% SEC yield is underwhelming, and Mansukhani points out that the fund's muted risk profile means that it didn't partake of the rally in lower-rated or long-dated bonds as much as many of its peers did. That said, its low-risk profile, experienced management, and low costs are strong selling points.

Category: Short-Term Bond | Analyst Rating: Silver | Average Credit Quality: AA

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