BondsOnline Advisor

Lowering Risk With Intermediate Bonds

by Stephen Taub

Let's face it. The Federal Reserve is going to raise rates many more times over the next few years before it is finished tightening.

Does this mean investors should watch this ascension from the sidelines and shun bonds altogether? No.

As we have pointed out in this space in prior columns, there are a number of strategies that make sense in an interest-rate-tightening environment. But, you must be careful.

"The most obvious way to guard against rising rates is to focus on bonds (and bond funds) with low duration, because duration measures how sensitive a bond is to changes in interest rates," Morningstar recently counseled its readers. "Low-duration bonds don't fall as much when rates rise as higher-duration bonds do, at least in theory."

Trouble is, low-duration bonds don't fare as well when rates fall. What's more, if investors move aggressively into these short-term bonds before rates rise, they can become pretty pricey.

In fact, year-to-date, short-term bond funds are only up about 1.1% on average while long-term bond funds have risen by 3%, according to Morningstar, the mutual fund research firm.

So, one strategy Morningstar has been pushing is intermediate bond mutual funds. It says a good middle ground would be to look for intermediate-term bond funds that have shortened their duration in anticipation of rising rates.

In recent months it has singled out three or four such funds whose durations are below five years.

Morningstar recently screened for intermediate-term funds that are open to new investors and have minimum initial investments below $10,000.

At the same time, it shunned funds with short-tenured managers, below-average performance, and high Morningstar Risk scores. It also eschews funds whose expense ratios exceed 0.80%.

One of a handful of funds in this group that Morningstar recommends is the FPA New Income fund (FPNIX), run by Bob Rodriguez, a well regarded fixed-income fund manager for many years. "Rodriguez has been expecting higher rates since last year, and he has accordingly taken his fund's duration down into short-term territory, far below the intermediate-bond average," Morningstar recently pointed out.

It is up 2% so far this year, partly because its duration is only slightly above one year. It also enjoys a 5.41% three-year annualized return. Its expense ratio, meanwhile, is a mere 0.61%. "This is one of the best bond funds money can buy," Morningstar says in a report on the fund.

The Constellation Clover Core Fixed Income fund (TCFIX) has also been a Morningstar favorite for awhile. However, the mutual fund research firm is seemingly losing a little interest in this portfolio, noting, "This fund boasts experienced management, but its potential risks and rising price tag make us wary."

Perhaps it's because the fund's duration is now slightly below five years while its expense ration has risen to 0.78%

The Fremont Bond fund (FBDFX) offers investors a no-load way to invest with legendary bond manager Bill Gross. In fact, its expense ratio is a mere 0.61%. The fund, which eschews US government bonds in favor of foreign paper, is up 3.2% year-to-date and its duration is 4.51 years.

"This is still one of our favorite funds, but for now it's not one to put in the drawer and forget," says Morningstar.

And then there is the TCW Galileo Total Return Bond fund (TGLMX). "This fund has a lot going for it," says Morningstar. "Its managers emphasize mortgage bonds with predictable cash flows and undemanding valuations."

They know what they are doing. The fund is up 3.7% so far this year and has racked up a 6.7% annualized return over the most recent three years and more than an 8% annualized return over the past five years. Says Morningstar, "It may hit a blip now and then, but this fund is otherwise a juggernaut." 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.