Goldberg's Picks: The 4 Best Bond Funds for 2011

Income investors face enormous challenges this year. Two of the most-common methods for boosting yield -- investing in long-maturity bonds or buying lower-quality junk bonds -- carry inordinate risks. If you take either approach, you may well lose more in principal then you gain in income. If long-term interest rates rise, as they have for most of the past three months, funds that invest in long-maturity bonds will take a licking (bond prices move in the opposite direction of interest rates, and the longer a bond’s maturity, the more its price moves with changes in rates). If the economy weakens, junk bonds, which have performed spectacularly for the past 22 months, will likely slip.

So what should you do now? Obviously, you should avoid long-term funds and those that invest exclusively in junk. Several out-of-the-mainstream bond funds look particularly appealing.

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Before we get to the hidden gems, though, let’s start with a plain- vanilla municipal-bond fund. You should put most of your taxable bond money in Vanguard Intermediate-Term Tax Exempt (symbol VWITX). This fund invests in high-quality municipal bonds. Average credit quality is a sterling double-A. Expenses are just 0.20% annually, and the fund yields 3.2%. That’s the equivalent of a taxable yield of 4.9% for an investor in the top federal bracket of 35%. As Ken Volpert, a longtime bond-fund manager at Vanguard, puts it, “Boring is beautiful.” With state and local governments facing their most dire financial crisis since the 1930s, I heartily agree.

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Still, no investment is immune from losses. As yields jumped in the fourth quarter and some investors dumped munis because of concerns about a rise in defaults, the Vanguard fund shed 3.6%. If rates rise another percentage point, the fund should fall about 5.5% in price. But that’s a lot less than long-term funds will surrender. Last year, the fund returned 2.1%.

Now for some places to take intelligent risks with your bond money: Start with DoubleLine Total Return Bond N (DLTNX). Lead manager Jeffrey Gundlach and co-manager Philip Barach chalked up a superb record investing in mortgage-backed securities while running TCW Total Return Bond I (TGLMX) from 1993 through 2009, returning an annualized 7.2%. TCW fired Gundlach in December 2009, but Barach and most of the fund’s analysts followed Gundlach to his new firm. TCW and Gundlach are enmeshed in a bitter legal fight.

That’s undoubtedly a distraction for Gundlach, but he still seems intensely focused on investing. Although DoubleLine Total Return began operating only in April, it managed to return 16.6% through the end of December.

Gundlach and his team are investing about half of the fund’s assets in long-term, government-backed mortgage securities. But the other half is in non-government-backed mortgages, including some subprime and Alt-A mortages (the latter type given to borrowers a cut above subprime but not as solid as prime), which are selling at steep discounts to their original prices. Gundlach and his analysts have the expertise and savvy to sort the wheat from the chaff in this dangerous sector. Moreover, the fund shouldn’t be hurt much by rising interest rates. If rates rise one percentage point, figure on its share price declining about 3%. Meanwhile, the fund yields about 8%. Annual expenses are 0.74%.

The world’s best growth story in 2011 will likely continue to be emerging markets. Pimco Emerging Local Bond D (PLBDX) may well be the best way for bond investors who prefer to avoid paying commissions to profit from the debt issued by developing-market governments and companies. The fund invests in bonds denominated in the currencies of emerging nations. So it will benefit as the dollar declines against those currencies, a likely scenario given the improving economies of developing nations and the relatively stagnant U.S. economy. Manager Michael Gomez sticks to relatively high-quality bonds. Over the past three years through December 31, the fund returned an annualized 8.8%.

Emerging Local Bond faces some headwinds. Rising inflation in emerging economies could push up interest rates, forcing down prices for emerging-markets bonds. If rates rise by one percentage point, its price should drop by 4.5%. The bigger risk is a financial crisis that causes investors to lose faith in emerging nations. This is a good fund, but a risky one. A negative: Annual expenses are an onerous 1.35%.

Another Pimco fund is also among my picks for this year. Pimco Unconstrained (PUBDX) offers investors the full expression of Pimco’s views on the bond market. Most bond funds, including the gargantuan Pimco Total Return (PTTDX), are what the industry calls “benchmark constrained.” So, for instance, if Pimco thinks there’s a lot of value in emerging-markets bonds, Total Return might put 5% to 10% of its assets in that sector. But no matter how bullish Pimco might be on developing nations, it won’t invest much more, wary of straying too far from its benchmark, Barclays Capital U.S. Aggregate Bond index. Unconstrained, by contrast, can place up to 50% of its assets in emerging markets. The fund can even short the bond market -- that is, bet that interest rates will rise, thus pushing down bond prices. Unfortunately, the expense ratio is high at 1.30%.

I don’t always agree with Pimco. But Bill Gross may well be the best bond-fund manager of this generation, and, as Pimco’s assets have mushroomed, he has assembled an increasingly large group of equally smart people. Consequently, Pimco’s forecasts have been among the best in the business. That makes this fund, under the leadership of Chris Dialynas, a fine choice. I doubt that the fund, which gained 5.2% in 2010, will blow up because of a disastrous management decision. In fact, if it disappoints, I think it will probably be because of the innate conservatism of Pimco and of Dialynas. Not bad traits in bond managers.

SEE MY PICKS FOR THE 5 BEST STOCK FUNDS FOR 2011

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C., area.