10 Questions With Bond Fund Watcher Eric Jacobson - TheStreet

Go ahead and buy a bond fund -- everybody's doing it.

In the first eight months of this year, investments into bond funds outpaced redemptions by $61.3 billion, reversing $42.2 billion in net outflows over the same stretch last year. This year's bond inflows top stock funds' $42 billion inflow. Why? The average U.S. stock fund is down about 20% over the past 12 months, while the average bond fund is in the black.

It's practical to seek shelter in the less-volatile world of bond funds. But many of us know little about that world. For much of the 1990s, bonds were an afterthought thanks to stocks' record-setting gains. The upshot: Yes, it's sensible to slug some of your portfolio into a solid bond fund, but finding one isn't exactly a no-brainer.

The undisputed king of bond funds is Bill Gross, manager of the (PTTAX) - Get Report Pimco Total Return fund and the (FBDFX) Fremont Bond, which we inducted into our Ima Winner Fund Club last week. Gross manages north of $220 billion and is the only fund manager to win Morningstar's coveted Manager of the Year award twice.

To help us figure out how much money we should have in bond funds and which ones are worth our money, we've tapped an expert: Eric Jacobson, fixed income editor and a senior fund analyst at Chicago fund-tracker Morningstar. For a quick and dirty intro to bond funds, read on.

1. People are piling into bond funds these days to lower their volatility, but some say a long-term investor shouldn't bother. What's the case for including bond funds in your portfolio?

Well, even if you're a long-term investor, you may have near- to intermediate-term goals like a college education or a down payment that could warrant investing in something with a lower risk profile than stocks. Bond funds are entirely appropriate tools to use in these cases. The key is that you should always let the goals drive your asset-class allocation, rather than using the market's tenor to drive your decisions.

Even for long-term investors with no near-term goals, however, it may make sense to allocate a modest portion of a portfolio to bonds. One reason: to sleep better. There are many people who loaded up on stocks over the past few years, only to learn that they don't have the constitution to withstand the volatility that stocks can produce. There's something to be said for the diversification advantage of bonds.

It's true that a portfolio with some bonds isn't likely to beat an all-stock portfolio over, say, 10, 20 or 30 years. But there are no guarantees, and it's at least within the realm of possibility that a couple of bad bear markets could dig deep enough holes in a

stock-heavy portfolio to make climbing back out a real struggle. Putting, say, 20% of a very long-term portfolio into bonds would, at least, provide some cushion, and in periods like the last 18 months, some real balance.

After all, the

S&P 500

has lost more than 17% in 2001, while the Lehman Brothers Aggregate Bond index, the bond-market benchmark, has gained nearly 9%.

2. For an investor with a moderate risk tolerance, how much of their portfolio should be in bond funds if they're more than 10 years from their goal, vs. when they're five years away?

There are rules of thumb for this, and I think it's important for investors to recognize them as such; they're not infallible. As the question implies, however, an investor's goal and risk tolerance should drive this decision.

That said, for someone with at least 10 years to go, some would argue for a 100% stock portfolio. I think that's a bit extreme, particularly if you're more than, say, 45 years old. Others would tell you to simply subtract your age from 100 and put the balance in stocks. That's only 55% for the 45-year-old, however, and I think that's a little too conservative for many people.

My instinct is that for most mature adults with at least 10 years until they reach their goal, a 20% bond-fund allocation should be a starting point to build upon. Once you're at five years, it makes sense to begin scaling back on stocks and adding to bonds. It's critical not to eliminate stocks completely because they're an investor's best bet to maintain purchasing power during the retirement years.

3. Typically, experts say most investors should look in the intermediate-term bond-fund category for a core bond fund, while aggressive types might look in the multisector or strategic income pile. What's your opinion?

I think just about any bond investor should start with a core

intermediate-term bond fund and build from there. If you're going to go the route that includes

high-yield and foreign bonds, as multisector/strategic income funds do, I'm in favor of picking individual funds that focus on those areas.

The multisector format has a conceptual appeal because it offers the promise of stability through sector diversification, but, in practice, almost every multisector fund on the market is managed for a high yield so that it's easier to sell. That has historically meant extra risk and sector bets made for the wrong reasons. By going the individual fund route, you get to pick specialist managers who really know each of those sectors well.

4. What funds stand out as being solid choices for someone who wants to own one core bond fund? Everyone mentions Bill Gross' Pimco Total Return or Fremont Bond, for good reason. What are some other choices?

I've got a few favorites. The easiest to recommend is the

(VBMFX) - Get Report

Vanguard Total Bond Market Index fund, managed by Ken Volpert. I like to joke that he's the bond market's answer to

(VTSMX) - Get Report

Vanguard Total Stock Market Index fund manager Gus Sauter. Like Gus, Ken is an extremely sharp guy who does a great job within the framework of a well-designed fund. And of course, it's dirt-cheap.

The no-load fund's 0.22% annual expense ratio is well below its average peer's 1%.

I also like the

(MWTRX) - Get Report

Metropolitan West Total Return Bond fund. It's run by a team of guys who started at Pimco, built a solid record at Hotchkis & Wiley before it was bought by Merrill Lynch, and then set out on their own at Met West. They've done wonderfully over the past several years, and though their asset base has grown tremendously, it remains much smaller and more nimble than Pimco's.

Another great choice would be the

(WATFX) - Get Report

Western Asset Core fund, which is an institutional fund, but can be purchased at reasonable minimum investments through some of the fund supermarkets, including Charles Schwab. This fund is very popular with discerning institutional investors.

5. What are the hallmarks of a good bond fund?

The best bond funds almost always have modest expense ratios, very well-defined investment mandates and easily understood risk controls. As part of that, many also keep interest-rate bets firmly in check, and focus most of their energy on sector and individual bond selection. There are good funds that cut a more aggressive profile than what I've laid out, but not too many.

6. People often think bonds are a riskless investment, but that's not the case when we think of high-yield funds and emerging markets funds. Let's start with high-yield funds, which are in the red on average over the past three years. What's gone so wrong?

The groundwork for this high-yield debacle was laid in the mid-1990s when investors were so smitten with junk that investment bankers were able to sell the bonds of upstart technology companies (telecom in particular) that had very weak business plans at yields that weren't nearly high enough to compensate for their inherent risks. This happened in part because the high-yield market is so driven by mutual fund flows, and even managers who were somewhat skeptical about the raft of small telecom deals coming to market felt that they had to buy in order to keep their funds from building up cash.

Why You Bother With Bonds: Lower Risk
Putting just 10% of an all-stock portfolio in a vanilla bond fund would've lessened your losses

The other key is that the junk market isn't like the stock market. We tend to like the idea of stock indexing because we see the stock market as one big balanced collection of companies of all stripes and sectors, and to a large degree it is. The junk market, however, is comprised of issuers who need to borrow money and are willing to pay a high price for it. That tends to skew it in favor of cash-hungry industrial companiesor those that need money for a turnaround of some kind.

On the other hand, it has also been the playing field for industries that need cash to build out big investments for their businesses, such as cable, gaming and telecom. Because of its heft, the telecom industry floated an enormous amount of paper in the 1990s and came to be the lead sector ofthe junk market.

The rest of the story is well-known. When the telecom sector came unhinged, theprospects for bond repayments did, too. And even those companies that are otherwise likely to survive have found it difficult to continue financing their operations in the junk universe because yields have gone so high and demand has been so weak.

7. Will redemptions from high-yield funds make matters worse?

It will be quite difficult for the market to really recover as long as redemptions are an issue. That said, many market watchers believe this could be the bottom for high yield. After all, with yields that run roughly 900 basis points over comparable Treasuries, you don't even have to see any price appreciation in order to generate excellent total returns over the next many months. And if the market does improve, all the better. I'm not making a call on high yield, though. It's difficult to know when the economy and the junkmarket might turn around, particularly with the fund-flow factors being what they are.

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8. What's your take on emerging markets bond funds? It would seem hardto shoehorn these into most portfolios.

Emerging markets bond funds are speculative, and I don't think anyone really needs them, though their yields can be extremely tantalizing. For the intrepid, however, I'd strongly suggest buying them only on the margins of a portfolio with the full knowledgethat they can be extremely volatile. Their volatility is along the lines of stock funds'.

9. What's a common mistake investors should keep in mind as they consider investing in bond funds?

Don't just judge funds by their yields. The biggest problem with yield is that it's really just a snapshot in time of how much income a fund (or bond) is generating relative to its principal amount. It doesn't tell you anything about the fund's history nor very much about its prospects, though, and can be really misleading. A terrible bond fund that loses a ton of money, for example, will almost certainly find itself with a beautiful yield, simply because its monthly dividend stayed the same while its net asset value has plummeted. That said, truly income-focused investors will want to know how much yield a fund is generating. It's best to make sure that a fund with a fat yield also has a respectable total-return record as well.

10. What are a few intermediate-term bond funds that might look good relative to stock funds' losses, but aren't good relative to other bond funds?

There are a number of them in the intermediate categories right now, just because it's been easy to make money in bonds this year. Remember how good all tech and growth funds used to look?

(INBNX)

AXP Bond,

(PINCX) - Get Report

Putnam Income

a member of

TSC's

Ima Loser Fund Club and

(SZIAX) - Get Report

Scudder Income are all examples of funds that have decent absolute recent returns, but aren't really very competitive vs. their peer groups and haven't proven themselves to be good long-term investments.

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.