The Big Screen: Bond Funds That Can Keep You Afloat

 



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The tide of cash gushing into bond funds is rising, and today the Big Screen is here to help you choose wisely.

Even before the Sept. 11 terrorist attacks, bond funds were beating stock funds handily. They had netted about $50 billion in 2001 inflows, about 10 times that of stock funds, according to liquidity tracker TrimTabs.com. No doubt the buy-bonds trend has continued since then, judging by stocks' performance over the past week. We've shown you how adding bond funds to a stock portfolio can whittle volatility while preserving returns, though bonds are far from riskless themselves. (For more on getting starting in bond investing, check out this primer.)

Money and confidence have drained from the bond market since the attacks, making funds that sink your money into below-investment-grade or junk bonds particularly vulnerable. If you're sitting with a stock-sick portfolio and already have an emergency stash equal to three months' expenses in the bank, these bond funds should work as a core holding for just about any investor.

We sifted vanilla intermediate-term bond funds, which spread their money among U.S. government and higher-quality corporate bonds. First, we yanked out any funds that didn't beat their average peer over the past one, three and five years. Then we removed any funds with volatility or expenses above the category average -- high expenses are particularly erosive with bond funds, where returns are typically lower than stock funds. Finally, we pulled out funds with more than 5% of their money in junk bonds, as well as those that are closed to new investors or carrying a high investment minimum.

(One thing to keep in mind as you survey the broad bond-fund landscape is that low-quality or junk bonds are probably a must-miss. Given investors' current distaste for anything that smacks of risk, many of these bonds are either trading at steep discounts or not trading at all. Obviously, that's not what you want in a core bond portfolio.)

We ranked the survivors by their annualized returns over the past five years. Here's our top 10:

Ten to Consider
The cream of the intermediate-term bond fund crop
Fund 5-Year Return 1-Year Return
(FBDFX)Fremont Bond 8.9% 13.7%
(USAIX)USAA Income 8.4 13.5
(VBIIX)Vanguard Intermediate-Term Bond 8.4 15.5
(SRBFX)Stein Roe Intermediate Bond 8.3 14.1
(PGBOX)One Group Bond 8.2 14.6
(DODIX)Dodge & Cox Income 8.2 14.1
(SWLBX)Schwab Total Bond Market 8.2 13.5
(VBMFX)Vanguard Total Bond Market 8.2 13.4
(HABDX)Harbor Bond 8.2 12.2
(VFICX)Vanguard Intermediate-Term Corporate Bond 7.9 14.2
Avg. Peer 7 11.6
Source: Morningstar. Returns through Sept. 17.

There are some all-stars on this list, including actively managed funds and those that passively track an index.

Pimco bond guru Bill Gross, the only fund manager to win Morningstar's coveted Manager of the Year honor twice, runs the no-load (FBDFX)Fremont Bond and (HABDX)Harbor Bond funds. True to form, Gross and his team make few bets on industry sectors or interest rate changes, but most of those bets have worked out. The Fremont fund beats at least 90% of its peers over the past one, three and five years, while the Harbor fund tops at least 70% of its competitors over the past one, three, five and 10 years. Each fund's expense ratio is about 0.60%, well below the category's 1% average, according to Chicago fund-tracker Morningstar.

Another solid, actively managed choice is the no-load (DODIX)Dodge & Cox Income fund, where Dana Emery has led the fund's management team since its 1989 launch. To make the fund less vulnerable to interest rate shifts, the team typically builds a portfolio of bonds that average a shorter duration than its benchmark, the Lehman Brothers Aggregate Bond Index. Its thoughtful approach has kept the fund ahead of 88% of its peers over the past one, three, five and 10 years. Its annual expense ratio is a low 0.46%.

Why You Shouldn't Ignore Bonds
A core bond fund would've helped over the past year
1-Year Return 3-Year Return
Intermediate-Term Bond Funds 11.6% 5.5%
Avg. U.S. Stock Fund -25.2 5.5
S&P 500 -28.2 1.9
Source: Morningstar. Returns through Sept. 17.

Index funds are also a great choice among bond funds, since they tend to offer diversification with ultralow expenses. Two on our list are from index-fund titan Vanguard: the (VBMFX)Vanguard Total Bond Market fund and the (VBIIX)Vanguard Intermediate-Term Bond fund, both run by veteran Kenneth Volpert since the funds launched in 1992 and 1994.

The Total Bond Market fund has a misleading label. It tracks the Lehman Brothers Aggregate Bond Index, which doesn't include dicey fare like junk bonds with high yields and high risks of default. The fund tops at least seven in 10 competitors over the past one, three and five years and carries a minuscule 0.22% expense ratio. The no-load (SWLBX)Schwab Total Bond Market fund tracks the same index, but is only available through Schwab accounts and carries a higher 0.35% expense ratio.

Vanguard's Intermediate-Term Bond fund tracks the Lehman Brothers 5-10 Year Government/Credit index. That's essentially the same as the Aggregate Bond Index, but it's a bit less diversified because it doesn't include mortgage- or asset-backed bonds. The fund might be worth that modest risk because it beats a jaw-dropping 95% of its peers over the past five years.

You might be tempted by Vanguard's third fund on our list, the (VFICX)Intermediate-Term Corporate Bond fund, which is actively managed by co-managers Ian MacKinnon and Robert Auwaerter. It makes our cut, but might not be for every investor out there. Because it focuses primarily on corporate bonds, it tends to get pneumonia when they get a cold -- unlike competitors whose government-bond holdings limit their downside risk. Still, the fund beats at least 75% of its competitors over the past one, three and five years, meriting a look for more aggressive investors.

There you have it, a menu of solid bond funds that bond-hungry investors should consider putting at the heart of their portfolio.

>To order reprints of this article, click here: Reprints

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to imcdonald@thestreet.com, but he cannot give specific financial advice.

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