Reassessing Bond Funds

10/21/2013


For many bond investors, 2013 has been a forgettable year. Through Oct. 15 the Barclays Aggregate Bond Index, which tracks more than 8,500 investment-grade bonds such as Treasurys, corporates, and mortgage-backed securities, was down 2.1% and on course for its first negative year since 1999. 

This year's weak returns and rising interest rates have some investors rethinking their allocation to bonds. The yield on the closely watched 10-year Treasury note now stands at 2.8%, up a full percentage point from May 1. With the Federal Reserve expected to wind down its massive bond-buying program in 2014, the prospect of even higher rates looms. As you consider your bond holdings, keep the following points in mind:

• Interest rates are notoriously difficult to predict. Many factors beyond the Fed will impact yields, including inflation, the outlook for economic growth, and even employment levels.

• While bond prices tend to move in the opposite direction of Treasury yields, other factors also affect bond-fund results, including investor return expectations, market liquidity, changes in an issuer's credit fundamentals, and currency fluctuations.

For example, in 2009 the yield on the 10-year Treasury rose to 3.9% from 2.2%. That year investors flocked to higher-yielding corporate bonds, helping the average intermediate-term bond fund return 14%, far outstripping government-bond fund returns.

• To mitigate risk, investors should hold a variety of bonds. But we are emphasizing short-term bonds in our fund picks. Besides generally performing better when rates rise, short-term bond funds replace their holdings more often than long-term funds. Proceeds from maturing bonds can be reinvested at higher and higher yields.

Nearly all bonds and bond funds face interest-rate risk, which increases with a bond's time to maturity. The shorter the duration, the less potential to be torpedoed by rising rates. A fund with an average duration of three years will see its share price fall roughly 3% in response to a one-percentage point increase in interest rates.

Our recommended funds are slanted toward short-term corporate bonds. Thompson Bond ($12; THOPX) holds mostly short-term U.S. corporate bonds (duration of three years) and yields 3.3%. Vanguard Short-Term Investment-Grade ($11; VFSTX), a longtime favorite, yields 1.6% and has a duration of only 2.3 years.

Investors seeking higher yields might consider Fidelity High Income ($9; SPHIX). Yielding 5.2%, the fund invests in junk bonds, which behave more like stocks and tend to react less to changes in interest rates.

PIMCO Total Return ($106; BOND), an exchange-traded fund managed by renowned investor Bill Gross, is a good all-weather pick. Down 1.3% so far in 2013, the fund yields 1.7% and has a duration of five years.

Investors willing to take on higher risk might consider bank-loan funds. Up an average of 4.1% this year, the funds invest in corporate debt with floating interest rates. Because their rates fluctuate, bank-loan funds tend to respond less to interest-rate movements than traditional bonds. The Forecasts doesn't recommend a bank-loan fund, but one worth watching is Fidelity Floating Rate High Income ($10; FFRHX), which yields 2.6%.


OUR RECOMMENDED MUTUAL FUNDS
Through Oct. 15, our Growth Portfolio has gained 20.1% so far this year, versus 19.1% for its benchmark portfolio. The Conservative Portfolio is up 17.8%, versus 13.4% for its benchmark.
Year-To-Date *
--- % Of Portfolio ---
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating †
Artisan International ($29; ARTIX)
16.6
A
9
9
97
Dreyfus Midcap Index ($36; PESPX)
23.8
C
0
0
51
Dreyfus Small Cap Stock Index
($28; DISSX)
29.5
B
0
0
87
Fidelity High Income ($9; SPHIX)
4.0
C
5
4
59
Homestead Small Company
($34; HSCSX)
26.2
D
5
8
99
PIMCO Total Return ETF
($106; BOND)
(1.3)
C
6
0
NA
T. Rowe Price New Horizons
($45; PRNHX)
36.5
A
9
9
98
T. Rowe Price Value
($33; TRVLX)
25.9
A
8
9
96
Thompson Bond ($12; THOPX)
1.5
A
6
0
95
Vanguard 500 Index ($157; VFINX)
20.9
C
6
7
70
Vanguard Dividend Growth
($20; VDIGX)
21.2
C
12
12
94
Vanguard GNMA ($11; VFIIX)
(1.9)
B
0
0
89
Vanguard Growth Index
($44; VIGRX)
20.6
D
11
11
81
Vanguard Inter.-Term Tax-Exempt
($14; VWITX)
(2.2)
B
0
0
79
Vanguard Selected Value
($27; VASVX)
29.8
A
5
7
100
Vanguard Short-Term Invest.-Grade
($11; VFSTX)
0.5
B
0
0
86
Vanguard Total Bond Mkt. Index
($11; VBMFX)
(2.2)
D
0
0
31
Vanguard Total Int'l Stock Index
($16; VGTSX)
11.3
D
0
0
27
Vanguard Wellesley Income
($25; VWINX)
5.3
B
0
0
95
Vanguard Wellington ($38; VWELX)
13.2
B
6
9
94
Wasatch International Growth
($29; WAIGX)
22.6
B
7
8
94
Wells Fargo Advantage Discovery
($33; STDIX)
32.0
A
5
7
94

* Year-to-date ranks through Oct. 15 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%.
† Fund ratings are percentile ranks based on our fund-rating system.


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