Why You Belong In Bonds

Even when rates rise, bond funds provide a market cushion. We've done the math to find the best ones for right now

The fear of rising interest rates and higher inflation has sent many investors in bond funds heading for the exits. Investors yanked nearly $4 billion from bond mutual funds in October and November -- the latest industry data available -- while pouring a record $40 billion into stock funds.

Investor concerns are valid, but dumping fixed-income funds could be a mistake. Bonds belong in most portfolios. They provide both a cushion from the stock market's bumps and a steady income stream.

You don't want to be out of bond funds altogether, but you want to be in those best suited for the period ahead. The BusinessWeek Mutual Fund Scoreboard can help you get your fixed-income plan in place. These tables feature all the bond funds with the top ratings, either compared with the wider bond-fund universe or compared with their peers. Fund data and ratings are prepared for BusinessWeek by Standard & Poor's (MHP ).

To come up with a rating, which goes from A to F, we start with funds that have at least five years of returns. We measure each fund's monthly performance for the past 60 months. When a fund fails to beat the return for U.S. Treasury bills, it earns negative marks, which are then subtracted from the total return. We rerank the funds on these risk-adjusted results. Only 105 funds ended up on the A list for overall performance (taxable and tax-free funds are rated against each other). We then run the ratings for each category of funds, such as high-yield, intermediate government, or short-term municipals. The result: 96 funds rated A when compared with their peers. The Scoreboard that follows features all funds with at least one A rating (66 funds have two As). An interactive version of the entire Scoreboard can be found at http://bwnt.businessweek.com/mutual_fund/.

LOW FEES, HIGH PERFORMANCE. Scandal-weary fund investors take note: Only a handful of funds from firms tainted by the investigations are on our A list. Many of the mutual-fund groups whose funds got top ratings are best known for fixed-income investing. In contrast, most improper trading in mutual-fund shares occurred at companies that specialize in growth-stock and international investing. Even so, the fund scandal has brought one issue to the forefront that has a big impact on bond funds: fees. Study after study shows that bond funds with low fees tend to be better performers. Returns are so much lower than returns on equities, so any cost savings go straight to the bottom line, boosting returns. You'll find plenty of offerings here from low-cost giants, such as Vanguard Group and Fidelity Investments. The expense ratios on Fidelity's municipal-bond funds, for example, have dropped roughly 8%, on average, since 1998. Perhaps that's why there are 14 of them on the overall A-list.

Bond funds are classified by categories -- such as general, government, or municipal -- as well as maturity. Short-term bond funds usually have average maturities of two to five years. Intermediate-term bonds tend to be concentrated in Treasury notes and other securities with maturities of 5 to 10 years. Long-term funds focus on bonds with maturities as long as 20 or 30 years.

These are crucial distinctions to make since rates are expected to climb. If you buy a long-term fund as rates start to rise and the prices of the bonds decline, you can blame only yourself for any losses.

Of course, a seasoned fund manager should be able to use a few tricks when interest rates start to move. Many of the managers at the A-rated funds on our list are already anticipating higher rates and buying shorter-term debt.

A good example: the $5.8 billion Dodge & Cox Income Fund (DODIX ). The A-rated portfolio has an average maturity of six years, a full year less than the Lehman Brothers Aggregate Bond Index. The scoreboard lists funds' average maturities.

One way to minimize risk is to seek bonds that are less sensitive to U.S. rates. Investors are doing that today by looking overseas, especially to emerging markets. Global economic growth, higher yields, and country debt upgrades provide good opportunities for fixed-income investors. Five years ago, 95% of the emerging market nations were junk-rated. Today, over 50% of the group is investment-grade. "It's a perfect world for emerging markets," says Mohamed El-Erian, who runs the A-rated PIMCO Emerging Markets Bond Fund and oversees $12 billion in emerging markets debt. Now, worldwide demand for commodities is helping the economies of resource-rich nations such as Russia and Brazil. El-Erian is betting heavily on both countries. His fund is up an annualized 22.6% over the past five years.

DEVELOPED NATIONS, TOO. Overseas opportunities go beyond emerging markets. The weaker dollar makes investing even in sovereign debt of developed countries attractive. Nearly 40% of A-rated Loomis Sayles Bond Fund is allocated to corporate and sovereign bond offerings of Canada, New Zealand, and Sweden. The $2.2 billion fund also owns euro-denominated debt issued by U.S. companies, including AT&T (T ) and Xerox (XRX ). "These euro credits are cheaper than what you could buy in the U.S., plus we are getting a credit we are comfortable with," says Kathleen Gaffney, who co-manages Loomis Sayles Bond and the Strategic Income funds, which is also A-rated.

Back in the U.S., one sector that is getting attention from investors is tax-exempt municipal bonds. That's because their credit quality is improving as states manage, cut expenses, and raise some taxes. "If this recovery continues, you'll see even more improvement in the states' financial picture," says Chris Ryon, who heads Vanguard's long municipal bond portfolios, 10 of which received A ratings.

Still, managing municipal bond funds demands rigorous research. While thousands of corporations are issuing securities, there are hundreds of thousands of issuers of muni debt. That's why Christine Thompson and her team at Fidelity Investments select bonds using fundamental research, zeroing in on a municipality's financial performance and issuance plans. "We do not allow the movement of interest rates to direct our portfolio," says Thompson. In fact, she's finding good opportunities in securities with 10-to-15-year maturities.

Intermediate-term muni-bond prices are generally less volatile than, say, U.S. government bonds. That's because a majority of muni bonds are stashed in the portfolios of individual investors who tend to buy and hold them. Still, at this point, long-term muni funds could be risky. But investors have plenty of choices among short- and intermediate-term funds.

HOME-STATE ADVANTAGE. When shopping for a muni fund, keep in mind that while the income is free from federal taxes, it's generally subject to state income taxes. There's one big exception: States don't usually tax the income from bonds issued within their borders. To take advantage of this, fund companies offer state-specific muni funds. For instance, with a New York muni fund, a New York investor would be exempt from both state and federal taxes.

Another way to dampen your portfolio's interest-rate risk is to invest in bonds that behave like stocks, such as convertibles and high-yield bonds. Both sectors rallied along with the stock market in 2003, each gaining over 25%. The much-improved economy bolsters balance sheets, and that's a plus for convertible and high-yield bond investors. Credit ratings are improving, and fewer issuers are in default. In fact, the default rate for high-yield bonds has dropped from nearly 10% in August, 2002, to just over 5% now. That figure should continue to slide as the economy expands.

Managers of such funds have to think a lot like equity investors, looking at a company's bonds as though they were buying its stock. Dianella Lipper Coules, portfolio manager of Neuberger Berman's (NEU ) High Yield Income Fund, owns bonds in Host Marriott (HMT ), the nation's largest lodging real estate investment trust (REIT). "The companies have upscale properties with a high barrier to entry and the ability to raise cash if necessary," says Lipper Coules. She's also anticipating an upturn in the travel industry.

Another way to insulate your portfolio from higher interest rates is through a fund that invests in Treasury Inflation Protected Securities (TIPS). Such bonds carry lower interest rates than conventional Treasuries, but the principal is adjusted upward if inflation climbs. These funds are relatively new, and there aren't enough of them yet to have their own category. Companies that offer TIPS funds include American Century, PIMCO, T. Rowe Price (TROW ), and Vanguard.

It's impossible to predict exactly when interest rates will rise. Instead, the smart investor is prepared for that move by being in the right sort of funds. You can shop for them here.

By Lauren Young and Toddi Gutner

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