In these times of economic uncertainty many investors are taking a closer look at bonds and bond funds. But if individual investors are looking for a safe place to grow their savings, they should select funds carefully. As the New York Times observed in a December 26 piece, Older Investors Should Examine the Risks in Bonds, "Because conditions may worsen before they improve, older investors should check that their bond investments are indeed what they thought they were--and that they fit their tolerance for risk." The article quoted Financial Counselors bond manager Gary Cloud: "We are in a 2 to 3 percent world, and if they want to earn more than that they need to proceed cautiously."
A WSJ January 4 piece In Search of Wall Street Bargains, carried Morningstar analyst Lawrence Jones' assessment of 2008 as an "absolutely brutal year" for most bond investors and observed: "Bond prices tumbled as investors anxious about the economic slowdown dumped corporate bonds and other obligations that carry the risk of default." Meanwhile, Treasury securities and the funds composed of them "delivered strong returns as investors bid up the prices of these safe havens."
Also on January 4, a Chicago Tribune piece, Bonds may be a shield, but they're still risky, echoed this theme. Noting that Steve Savage, editor of No-Load Fund Analyst, has advised individual investors to consider corporate bond funds and even high-yield bond funds, the Tribune warned, "Whenever yields are high, there is a good chance that financially stressed companies won't be able to repay their debts. In other words, bonds would default and investors would lose money."
I spoke with Morningstar's Miriam Sjoblom last week to gain some understanding of how to evaluate bond funds. That was just when Morningstar (NASDAQ: MORN), in a premium article on its Web site, named its favorite intermediate-term bond funds: Dodge & Cox Income (DODIX); Fidelity Total Bond (FTBFX), Metropolitan West Total Return Bond M (MWTRX), FPA New Income (FPNIX), Harbor Bond Instl (HABDX), TCW Total Return Bond I (TGLMX) and Vanguard Total Bond Market Index (VBMFX).
In a year when the average return for intermediate-term bond funds was negative 4.7%, the last four had positive returns in 2008 (of 4.3% , 3.3 %, 1.1 % and 5.1 %, respectively).
Sjoblom explained via email Morningstar's rationale for calling these funds favorites: "They have experienced management teams, strong analytical/research support, good track records, and low expense ratios. Low fees are particularly important for bond funds since their return potential is a lot lower than equity funds, and therefore expenses can take a bigger bite out of income and total returns and play a bigger role in separating the winners from the losers over the long term."
Interestingly enough, the WSJ's January 4 article noted of the intermediate-term bond category that "some strong-performing funds now have a lot of their money riding on mortgage assets, as their managers hope to sort out some mortgage-backed investments that have been wrongly maligned."
While investing in real estate might seem at best counterintuitive if not sheer suicidal, Sjoblom explained that many intermediate-term bond funds include agency mortgage-backed securities to create diversity. The Federal Reserve's conservatorship move last fall to bolster Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) along with the Fed of New York's purchase of some agency mortgage assets begun last week results in a rise in demand in these assets, Sjoblom said.
A rise in demand for agency mortgage-backed securities "leads to an increase in price for outstanding bonds and a decrease in yields (since price and yield move in opposite directions on bonds)," Sjoblom wrote me. "Mortgage-backed securities already owned by mutual funds are 'marked-to-market' every day, which means they are repriced daily according to prevailing market rates, so anything impacting the prices of bonds in the market would impact the prices of bonds owned by a mutual fund."
Of course the agency mortgage assets bought by the Fed, as the AP wrote last week, are probably from "higher-quality prime mortgages and not pools of subprime loans." So you may get a healthy slice of real estate along with your purchase of these bond funds.
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