Bond Funds Reduce Risk

If you were tempted to kick yourself during the bull market for keeping those stodgy bond funds in your portfolio, you're probably patting yourself on the back today. Bonds issued in the U.S. have returned 8% over the past year through mid February, taking at least some of the sting out of the stock market's 6% decline.

That's what bonds are supposed to do. Their relatively low volatility and steady interest payments are a source of comfort to investors when stocks falter. In the bear-market year of 2002, when Standard & Poor's 500-stock index fell 22%, the Lehman Aggregate Bond index gained 10%. As the U.S. headed toward recession in 1990, the bond index rose 9% as stocks surrendered 3%.

True, in the long run stocks will make you more money. Over the past 80 years, they've gained an annualized 10.4%, while long-term government bonds have returned 5.5%, only a couple of percentage points ahead of the inflation rate. But bonds are not the dead weight they may seem to be when good times are rolling. Their mere presence in your portfolio diversifies your holdings and dampens risk. Thus, bonds belong in nearly every long-term investor's portfolio.

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The Kiplinger 25, our list of the top mutual funds, has always included bond funds (five are on the current list). But many others deserve your consideration. So here is an expanded list of the top bond funds. We've divided the funds into three categories: safe taxable funds that could serve as core bond holdings (or even your only bond fund); aggressive funds that might play a supporting role in a bond portfolio; and municipal-bond funds, which offer tax-free income and are particularly beneficial to investors in high tax brackets. In assembling this list, we leaned toward funds that have long-term records of consistent perform-ance and low levels of risk within their categories, as well as low expenses.

Safe taxable bonds

Dodge & Cox Income (symbol DODIX) has a nearly 20-year history of producing above-average returns with low risk -- an ideal profile for a core bond fund. It primarily buys investment-grade bonds issued by strong businesses with good cash flows and mortgage securities backed by government-sponsored companies, such as Fannie Mae. The nine-person management team doesn't try to beat the indexes with interest-rate bets. Rather, the managers try, through extensive research, to find bonds with good yields that also have the potential to rise in price. The managers also move cautiously in selecting the fund's smattering of junk bonds; they look for mature businesses that are on the way to recovering their former investment-grade ratings.

Harbor Bond (HABDX) is a low-cost, low-minimum clone of a fund that Bill Gross runs for Pimco. Gross combines an uncanny sense of the economic winds with a keen eye for spotting pockets of value almost anywhere bonds are traded. He'll make bets on the direction of interest rates as well as on sectors, and he'll also invest at times in foreign and junk bonds. In Gross's hands, the bets are usually smart ones, and the fund is a solid core holding for any bond portfolio. (For a look at Gross's outlook on the economy and the bond market, see our interview with him.)

When recession is in the air, investors pile into U.S. Treasuries, which have zero risk of default. That's why a government-bond fund is a solid foundation for any portfolio. In this area, we like Fidelity Government Income (FVITX), which has a good record of supplementing relatively low-return Treasuries with higher-yielding bonds issued by government agencies and with high-quality mortgage securities. The fund's stellar 8% return in 2007 demonstrates how a conservative choice can be a lifesaver for your portfolio when the chips are down.

The subprime mess has given all mortgage-related investments an air of danger. But TCW Total Return Bond (TGLMX) is a safe way to invest in mortgage securities, one of the biggest sectors of the bond market. Manager Jeffrey Gundlach buys high-quality securities issued by the U.S. government, its agencies and government-sponsored firms, such as Fannie Mae and Freddie Mac, so there's little credit risk. This well-managed fund is worth considering if you like the safety of government bonds but want a higher yield. Like most other bonds, mortgage securities tend to lose value when interest rates rise. But because homeowners refinance when rates fall, mortgage securities don't appreciate as much as Treasuries in a bullish environment for bonds; they tend to do best when rates are stable.

Vanguard Inflation-Protected Securities fund (VIPSX) was up 12% last year as rising prices and falling interest rates sent investors scrambling for inflation protection. But even when inflation isn't on the front burner, it's good to have a bit of this fund in your portfolio because it gives you pure exposure to Treasury inflation-protected securities, or TIPS. Managers John Hollyer and Kenneth Volpert typically buy TIPS and little else. And because of their built-in inflation protection, TIPS perform differently than other types of bonds, making them good diversifiers for your bond portfolio.

Aggressive taxable bonds

Investing in foreign-currency-denominated bonds has been a good strategy for coping with a deteriorating dollar. But the greenback won't always be down and out. That's why we like Julius Baer Total Return Bond (BJBGX). Managers Richard Pell and Donald Quigley can dial up the fund's foreign-currency exposure to 40% of assets or down to zero, depending on their outlook for the U.S. and global economies (it's currently closer to the lower extreme). They'll also make sector and interest-rate bets, always sticking with investment-grade securities. The strategy's success depends on the managers' ability to make the right calls at the right time, and Pell and Quigley have done so consistently.

Loomis Sayles Bond fund is a rare bird. It's a true go-anywhere bond fund. Managers Dan Fuss and Kathleen Gaffney will invest wherever they find value, whether it's in Icelandic krona (a play on aluminum prices, says Fuss) or investment-grade industrial bonds. The two managers have the skill and experience to pull this off. Fuss has been with Loomis Sayles for 30 years and has managed the fund for almost 17; Gaffney joined him a decade ago. Loomis Sayles Bond (LSBRX) invests primarily in investment-grade corporate bonds, but Fuss and Gaffney can -- and do -- invest in lower-rated bonds, foreign and emerging-markets securities, government and agency securities, and preferred stocks. The managers have reduced risk over the years by spreading their bets over more than 500 securities.

Fidelity Strategic Income (FSIAX) is a more structured alternative to Loomis Sayles's go-anywhere approach. Manager Derek Young typically keeps 40% of the fund's assets in junk bonds, 30% in U.S. government securities, 15% in developed foreign markets and 15% in emerging markets. Each segment has its own day-to-day portfolio manager, and Young acts as maestro, bumping exposure to each segment up or down depending on where he sees the best opportunities. Although high-yield and emerging markets are among the bond market's riskier sectors, the fund's segments have different risk profiles, some of which offset others. The end result is a fund that offers extra yield without too much extra volatility.

The high-yield sector is the Wild West of the bond market. Here companies with iffy credit histories offer mouth-watering yields in order to attract buyers to their bonds. Although defaults have been relatively rare in recent years, things could change as the U.S. economy slows. Mark Vaselkiv, manager of T. Rowe Price High Yield (PRHYX), sticks mostly to higher-rated, B and BB bonds (BBB is the lowest investment-grade rating) and spreads his risk over more than 300 holdings. That makes this fund a relatively tame way to play the junk-bond market. It yields more than 8%.

The diversification that comes from owning foreign bonds can be healthy for your portfolio as long as you're able to cope with the unpredictability of currency fluctuations. Ian Kelson, manager of T. Rowe Price International Bond (RPIBX), tries to keep the ride as smooth as possible by sticking primarily to high-quality (triple- and double-A-rated) government bonds from developed countries, although he selectively buys corporate and emerging-market issues as well. Kelson mostly invests in bonds that are denominated in foreign currencies. He doesn't do much currency hedging, so fluctuating exchange rates will have a big impact on returns. That has worked in investors' favor in recent years, thanks to a weak dollar, but that won't always be the case. That's why this fund works best in a portfolio that has plenty of exposure to domestic bonds as well. The fund's average maturity was recently about nine years, which means it is somewhat susceptible to rising interest rates.

Tax-free muni bonds

Upheaval in the credit markets over the past six months has had a strange effect on municipal bonds, depressing values in an otherwise solid sector. With tax-free muni yields close to those of taxable Treasury bonds, now is a good time to buy. There's no better vehicle than Fidelity Intermediate Muni Income (FLTMX) for broad exposure to this market. The fund's track record is superb, and its manager, Mark Sommer, though relatively new, is backed by one of the best research operations in the business.

Vanguard Short-Term Tax-Exempt is a supersafe way to invest in munis. Manager Pamela Wisehaupt-Tynan keeps the fund's duration (a measure of its interest-rate sensitivity) low. She doesn't take on too much credit risk either, sticking mostly to AA-rated and AAA-rated bonds. You won't get rich with this fund (it hasn't earned more than 5% in a year since 1995), but neither will it impoverish you -- in its 30 years of existence, it's never had a negative year. As is typical with Vanguard funds, expenses are ultralow (0.16% per year), giving Short-Term Tax-Exempt a leg up on its rivals.

For high-income-bond investors with a taste for risk, a high-yield muni fund is a good place to look. Returns have little in common with other bond-fund returns, even those of taxable high-yield funds. So a high-yield muni fund is a good way to diversify your portfolio. Although muni-bond issuers rarely default, you still want a manager who is skilled at discerning good credit risks. Jim Murphy has guided T. Rowe Price Tax-Free High Yield fund (PRFHX) to consistently good returns through skilled bond selection, good sector bets and a strong sense of when to seek safety in higher-quality bonds when the market gets dicey. The fund, which has half of its assets in bonds rated BBB or better, sports a current yield of about 5%. That's equivalent to a taxable 7.7% for someone in the 35% federal tax bracket.

Use the Kiplinger Fund Finder to get data on taxable and municipal bond funds.