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Bond Funds

The performance of bond funds has been all over the map during the past year.

The performance of bond funds has been all over the map during the past year. Managers with skill and foresight were able to steer clear of minefields. By and large, bonds have proven their worth as a diversifying anchor in a portfolio. Moreover, the outlook for several categories of bonds looks bright even in this dark economy. Managers are finding some of the best values in corporate bonds, in particular.

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Tom Dugan, one of nine co-managers of Dodge & Cox Income (DODIX), says that the rotten economy could be good for bonds. His thinking goes like this: Credit markets are still fragile; it's still difficult to buy and sell bonds in the secondary market; and brokerage firms aren't committing much capital to the market. But, absent a depression, bonds of corporations that will survive the economic challenges are compensating investors well for risk. Remember, as a bondholder you just need the borrower to pay its debts, not increase profits, which is what stockholders seek.

Compared with its benchmark index, says Dugan, D&C Income has a relatively small position in government IOUs, which don't pay much, and a large allocation to corporate bonds. For instance, in December the fund bought Hewlett-Packard bonds that mature in five years. At that time, they yielded about five percentage points more than the yields of Treasuries of the same maturity. In early March, Dodge & Cox Income yielded 7.5%.

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The portfolio of Harbor Bond (HABDX) more or less reflects the distilled wisdom of Bill Gross and his colleagues at Pimco, which runs the fund. Mark Kiesel, a member of that team, lays out a bearish economic scenario: The banking system and process of asset securitization are broken and will take years to heal. Consumers will stay on a diet, and thus corporate profits will be squeezed. "Consumers have to live within their means now after 20 years of bingeing, which has significant implications for the economy," says Kiesel.

So what do Pimco's pros like? Kiesel says they favor high-quality corporate bonds, particularly in defensive and regulated areas such as health care, utilities and pipelines. Such bonds offer yields to maturity of 7% to 8%, he says. Pimco also likes "partnering" with the government in senior bonds in banks. Their shareholders may take a haircut, but bondholders will benefit from Uncle Sam's support. Kiesel says Pimco is also buying Treasury inflation-protected securities, or TIPS. Harbor Bond yields 4.9%.

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Whoever would have thought that managing a national municipal bond fund was an opportunity to shine? But that's just what Mark Sommer has done. Sommer took the reins of Fidelity Intermediate Municipal Income (FLTMX) in July 2006. Over the past three years, this fund has bested the Barclays Capital Municipal Bond index by an average of about one percentage point a year. Sommer is particularly proud that his fund eked out a 1% gain in treacherous 2008, a year when less-adroit muni funds plunged as much as 32% and most lost money. Fidelity's deep bench of bond analysts has come in useful as the value of the triple-A rating, which bond insurance once brought automatically, has come into question.

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Sommer says that when the muni market "blew up at the end of the summer of 2007, the fund was well positioned to withstand the storm." He had shed riskier issues and migrated to higher-quality bonds, including those from the health-care sector. His fund yields 3.3%, which is the equivalent of 5.1% for a taxpayer in the 35% bracket.

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Once inflation returns, Vanguard Inflation-Protected Securities (VIPSX) will strut its stuff. Ken Volpert, who runs the fund with John Hollyer, thinks that, relative to conventional Treasuries, TIPS still offer good value, especially those maturing in five to ten years. Volpert foresees a couple of years of deflation. But once the moribund economy bottoms, inflation will heat up because of enormous government efforts to stimulate the economy. For bonds maturing in ten years, TIPS will outpace regular Treasuries if the inflation rate exceeds 0.8% annually over that period. The fund yields a modest 1.8%, but that doesnUt reflect future inflation.

The managers of Loomis Sayles Bond (LSBRX) say the sweet spot of the bond market is in the lower end of investment-grade issues. Kathleen Gaffney, who manages the fund with Dan Fuss, says Loomis Sayles has loaded up on triple-B-rated media names, such as Comcast and Time Warner, along with a bunch of bonds issued by oil-service companies, such as Weatherford International and Nabors Industries. Loomis Sayles's working assumption is that the economy will begin to show some signs of life again in 2010. In the meantime, Gaffney says, "With yields where they are, you get paid handsomely to wait for the recovery." The fund yields 9.5%.

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