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Mutual Funds

Bond Funds That Put Cash in Your Pocket

We identify funds and ETFs that deliver the best yields without taking big chances.

Investors are on a hunt for income, and apparently, most prefer to pocket cash from bonds rather than stocks -- despite an abundance of bargain-priced blue chips paying attractive dividends. Over the past six months, investors poured $59 billion into bond funds, and withdrew $118 billion from U.S. stock funds.

SEE ALSO: Goldberg's Picks: The Best Bond Funds for 2012

Investors are voting for bond funds despite minuscule yields that are unlikely to rise anytime soon. The Federal Reserve plans to keep short-term interest rates low until mid 2013, and although long-term rates are more likely to rise than fall, sluggish economic conditions here and abroad suggest that any increase will be muted.

After reading the tea leaves, we decided that the best way to meet your needs was to identify the best-yielding bond funds for your money. You can boost yield by taking on more risk, by buying either bonds with longer maturities or those with lower credit ratings. In sifting through six bond-fund categories -- short-term, intermediate-term, municipal, mortgage, high-yield and emerging markets -- we looked for funds that offer the optimum combination of yield and safety. In particular, we considered how the funds weathered the calamitous year of 2008, as well as their relative volatility.


Our favorites deliver higher-than-average yields and solid long-term records for total return compared with their peers. In each category, we include two no-load mutual funds and, in all but one group, the best exchange-traded fund. We list the categories in order of ascending risk. (All results are as of December 31.)

Short-term bonds

The average short-term bond fund has a 30-day yield of 1.7% -- in other words, not much. But you can do better. Vanguard Short-Term Investment Grade (symbol VFSTX), a member of the Kiplinger 25, yields 1.9%, and USAA Short-Term Bond (USSBX) pays 2.5%. Both funds invest in short-term, investment-grade corporate bonds and have a duration (a measure of interest-rate sensitivity) of about 2 years. That means that for every percentage-point rise in rates, the funds should lose about 2%.

Vanguard's ETFs, which charge super-low fees, are hard to top, especially when yields are so darn low. Vanguard Short Term Corporate Bond Index ETF (VCSH) charges 0.14% in expenses and yields 2.3%. Its average duration is 2.8 years.


Medium-term bonds

In this category, we focused on funds that could move among corporate (foreign and domestic), government and mortgage-backed debt without taking on too much risk. The six managers at Baird Aggregate Bond (BAGSX) have been with the fund since its inception in 2000, investing in just such a mix of IOUs. These days, the managers have most of the portfolio invested in corporate bonds (41%) and mortgage-backed issues (36%). The fund yields 3.8%, and its ten-year annualized return of 5.6% beat about two-thirds of medium-maturity funds. Average duration is 5.0 years.

The yield on Fidelity Investment Grade Bond (FBNDX) -- just below 3% -- won't knock your socks off, but the fund's three-year annualized return of 10.6% outpaces that of its peers by an average of 1.5 percentage points per year. That’s big in the sedate world of bonds. Average duration: 5.1 years.

The go-to ETF in this group is, not surprisingly, Vanguard Intermediate-Term Bond (BIV). The fund has a microscopic expense ratio of 0.11%, a yield of 2.4% and an average duration of 6.4 years, and it offers broad exposure to government, government-agency and corporate bonds.


Municipal bonds

The doomsayers were wrong: Armageddon never came for tax-free bonds in 2011. In fact, the average intermediate-term national muni bond fund returned a solid 9% last year, mostly through capital appreciation. But don’t expect a repeat performance this year. Yields are historically low -- the ten-year, triple-A-rated muni benchmark recently hovered just below 2%. On a tax-equivalent basis, though, that's not so bad. For an investor in the 33% federal tax bracket, a 2% tax-free yield is equivalent to 3% from a taxable bond.

Fidelity Intermediate Municipal Income (FLTMX) may not do as well as its peers during muni-market rallies, but it shines during downdrafts. In 2008, it returned 1.0%, outperforming its benchmark by more than 3 points. The fund, a member of the Kiplinger 25, yields 2.0%, and its average duration is 5.2 years.

Another appealing choice is Vanguard Intermediate-Term Tax-Exempt (VWITX). The fund, managed since 2008 by Michael Kobs, yields 2.1% and carries an average duration of 5.5 years. Average credit quality is double-A, slightly better than the Fidelity fund’s average quality of single-A. Vanguard charges a low 0.20% annually for expenses.


Our favorite ETF in this category is also the oldest: Market Vectors Intermediate Muni ETF (ITM), which tracks Barclays Capital Intermediate-Term Municipal Bond index. Its 2.5% yield translates to 3.7% for investors in the 33% tax bracket. The ETF’s annual expense ratio is 0.24%.

Mortgage securities

The subprime-mortgage implosion in 2008 left a lot of investors leery of this category. But many mortgage securities have little to do with subprime loans, are backed by Uncle Sam and offer higher yields than Treasuries.

DoubleLine Total Return Bond (DLTNX), a member of the Kiplinger 25, has 87% of its assets in mortgage bonds. Managers Jeffrey Gundlach and Philip Barach balance government-agency mortgage-backed securities (47% of the portfolio at last report) with non-agency mortgage-backed bonds (35%). The former carry no default risk but a lot of interest-rate risk; the latter have little interest-rate risk but high default risk. The result: a low-volatility fund with a current yield of 8.0% and a 9.2% total return in 2011.

A more conservative choice: Vanguard GNMA (VFIIX). The fund sticks with bundles of loans guaranteed by the Government National Mortgage Association. As such, Uncle Sam promises timely payment of principal and interest. Wellington Management, currently represented by Michael Garrett, has run the fund since its launch in 1980. Over the past ten years, it gained 5.8% annualized, beating the typical intermediate government bond fund by an average of 1.0 percentage point per year. Current yield: 3.0%.

SEE ALSO: Goldberg's Picks: The Best Bond Funds for 2012

High-yield bonds

The term junk bond has given this category a bad rap. Of course, compared with investment-grade bonds, high-yield bonds -- those rated double-B and lower -- carry a greater risk of default. But in return, junk bonds pay more. In early 2012, the average junk bond fund yielded 6.9%.

To keep credit risk down, we favor funds that hold mostly single-B-rated bonds over those that load up on extreme junk. Fidelity High Income (SPHIX) and USAA High-Yield Opportunities (USHYX), both mutual funds, and iShares iBoxx $ High Yield Corporate Bond (HYG), an ETF, fit the bill and offer above-average yields. Fidelity manager Fred Hoff typically keeps a chunk of his portfolio -- recently 53% -- in single-B-rated corporate bonds, with only small positions in bonds rated C and lower. That strategy helped the fund in 2008, when it lost 23.7% -- not great, but 2.7 percentage points better than the average junk fund. High Income’s yield: 7.0%. USAA managers Matthew Freund and Julianne Bass steer their fund, which yields 7.1%, toward mostly double- and single-B issues (67% of the portfolio). The iShares ETF has an average credit quality of single-B and boasts a 7.3% yield.

Emerging-markets debt

Emerging-markets bond funds are having their moment in the sun. Since early 2011, the category has taken in $11 billion in cash, and 16 new funds have launched. No doubt investors are seduced by the high payouts -- yields greater than 5% are common. Plus, the bonds are getting less risky as the economies of many emerging nations improve and even surpass those of developed ones in both size and quality. John Carlson, manager of Fidelity New Markets Income (FNMIX), has consistently turned in good results; his 15-year annualized return of 10.9% outpaces the average emerging-markets bond fund by 1.0 percentage point per year. He favors dollar-denominated, investment-grade corporate and government bonds (49% of the portfolio is invested in issues rated triple-B or better). The fund yields 5.5%.

DoubleLine Emerging Markets Fixed Income (DLENX) is less than two years old. But manager Luz Padilla ran TCW Emerging Markets Income from 2001 through 2009, during which it returned 12.7% annualized, or 1.1 points per year better than the fund’s bogey. Last year, Padilla's 4.3% return at DoubleLine topped the average emerging-markets bond fund by 2.3 points. The fund yields 5.5%.

Among ETFs, consider PowerShares Emerging Markets Sovereign Debt (PCY). It tracks a dollar-denominated gov­ernment-debt index, yields 5.6% and charges 0.50% in annual expenses.