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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%.
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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.
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.
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