Last month, I discussed why owning bond funds still makes sense even if you think higher interest rates are coming. Before I name my favorites, I want to reiterate that I am not defecting to the Society of Interest Rate Scolds. I firmly believe that rates will remain low for much longer than most people expect.
Why am I so confident? For starters, all economic signs suggest that when the Federal Reserve finally lifts short-term rates, it will do so by no more than 0.25 to 0.5 percentage point this year, then keep them on hold until well into 2016. And don’t expect much action in the bond market, where investors set yields for longer-term debt. Think of bond yields simply as the cost of credit. The world is swimming in cash, and investors are eager to buy bonds at today’s prices. Their buying keeps yields down and prices up (the two move in opposite directions). So fears that a wave of selling is about to crush bondholders are unfounded.
But the endless chatter about the inevitability of higher rates complicates managing your bond fund portfolio. To get a decent yield while protecting your principal, you should own funds that focus on the tough task of actively buying and selling bonds. That way you may benefit from quick price movements and changes in credit ratings, as well as take advantage of the opportunities that are created when investors are forced to sell their bonds under duress. Such hands-on investing requires skilled managers, supported by smart analysts and agile traders. Index funds and funds run by managers who try to time swings in interest rates need not apply.
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Beyond seeking talented managers, what should you look for? Avoid funds with big stakes in Treasuries. Investors are most likely to dump government bonds if they need cash quickly. Stick with funds that have a short to medium duration, a measure of rate sensitivity. Holding some high-yield bonds is a reasonable strategy. Junk funds offer above-average yields and should hold their value better than investment-grade funds as yields rise. Below are my six favorite mutual funds.
Buffalo High Yield (symbol BUFHX, yield 3.0%) invests mainly in higher-quality, short-duration junk. It stays away from energy debt and occasionally holds convertible bonds to benefit from gains in an issuer’s stock.
Dodge & Cox Income (DODIX, 2.8%) has most of its assets in medium-maturity corporate bonds and mortgage securities; it has only 10% in Treasuries.
FPA New Income (FPNIX, 2.9%) passes along income from commercial and residential mortgages and offbeat asset-backed securities for things such as subprime car loans and airplane leases. The yield is surprisingly high considering the fund’s low average duration of 1.4 years.
MetWest Unconstrained Bond (MWCRX, 1.7%) can, as its name suggests, do anything in the fixed-income arena, including betting on bond prices to fall. The managers have been emphasizing mortgages and asset-backed securities, such as student-loan receivables. The fund, a member of the Kiplinger 25, has been tracking FPA New Income lately, which is good.
Osterweis Strategic Income (OSTIX, 4.1%), another Kip 25 member, was an early advocate of short-term junk bonds and continues to be effective in focusing on that area.
RiverNorth/DoubleLine Strategic (RNDLX, 5.3%) combines closed-end funds trading at discounted prices with the mortgage expertise of bond powerhouse DoubleLine. It sounds weird, but it works.
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