20141218=Our picks for fixed-income investors

By Adam Zoll   December 18, 2014 8:53 AM

So far this week, we've identified some of the best U.S. and foreign stocks and stock funds available to individual investors. But no survey of quality investment options would be complete without also looking at fixed-income vehicles, and bond funds in particular, which can provide ballast and diversification--not to mention income--to a portfolio.

For some individual investors, owning individual bonds may make sense. The problem is that investors may not have the time or inclination to research individual bond issues, whereas information and analysis on individual stocks is often readily available. That's why owning bonds through a mutual fund or an ETF run by an active manager or that tracks a broadly diversified index of bonds makes sense for many investors. (For more on deciding between individual bonds and bond funds, read this article by Christine Benz, Morningstar's director of personal finance.)

To help guide you toward some of the best bond funds available to individual investors today--meaning those rated Gold, Silver, or Bronze by Morningstar's bond-fund analysts--we've divided them into some key groupings below. We've excluded long-term bond funds for now due to their high sensitivity to rising interest rates, which many experts expect to see in the coming year (and despite the fact that long-term bonds have been among the best-performing bond categories this past year).

Active Intermediate-Term Bond FundsGiven all the interest-rate uncertainty, choosing a bond fund that is actively managed makes perfect sense for some investors. An active manager can tilt the fund's portfolio toward or away from shorter-duration issues and/or take calculated risks toward or away from lower-quality fare as he or she sees fit. Active management isn't for everyone, to be sure, but if ever there was a time to stick with quality active bond-fund managers, this is it. Morningstar's analyst team recommends the list of actively managed intermediate-term bond funds found here (Premium Membership required). It includes the funds below. (As with all the lists found in this article, only non-institutional share classes that are open to new investors are included.)

Dodge & Cox Income (DODIX): This fund's management team invests with a three- to five-year time horizon, balancing the goal of outperforming the Barclays U.S. Aggregate Bond Index with minimizing the risk of loss over that stretch. They also place an emphasis on income as a driver of total returns. In that vein, they aim to assemble a portfolio that delivers more yield than the index.

Fidelity Total Bond (FTBFX): Manager Ford O'Neil keeps this fund's duration close to that of its Barclays U.S. Aggregate Bond benchmark but is more adventurous when it comes to credit risk. The fund has the flexibility to buy emerging-markets bonds and can invest up to 20% in below-investment-grade debt. O'Neil, a Fidelity veteran, draws on the firm's deep bench of managers and analysts, including its well-respected government and high-yield teams, for input on valuations and security selection.

Index Intermediate-Term Bond FundsAs with stock index funds, bond index funds typically have a build-in pricing advantage as compared with their actively managed competitors. For those who prefer a passively managed intermediate-term bond fund, our analysts recommend the following.

Vanguard Total Bond Market Index (VBMFX): This fund attempts to replicate the performance of the Barclays Capital U.S. Aggregate Float Adjusted Index, a broad proxy for the investment-grade U.S. bond market. This index includes investment-grade corporate, government, and agency debt denominated in U.S. dollars. However, it excludes agency and mortgage-backed securities held by the Fed. The portfolio skews heavily toward government and securitized bonds--70% of the portfolio--much greater than the intermediate-bond category average. That gives the fund a higher-quality portfolio.

International-Bond Funds
Many investors take a distinctly U.S.-centric view when it comes to owning bond funds, but funds that own primarily foreign bonds can add diversification--and higher yields, in some cases--to a portfolio as compared with those owning primarily U.S. issues. Our analyst picks in the world-bond and emerging-markets bond categories can be found here, and include the following.

Fidelity New Markets Income (FNMIX): Manager John Carlson has owned as much as a low-teens stake in emerging-markets local-currency debt in the past, but hard-currency sovereign bonds remain this fund's bread and butter. That focus dates back to Carlson's 1995 start on this fund and goes against the recent proliferation of local-currency funds, which provide diversification away from the U.S. dollar. That said, the fund does court other risks. Carlson is willing to take on plenty of credit exposure if he thinks the price is right, for example.

Templeton Global Bond (TPINX): Manager Michael Hasenstab doesn't construct this portfolio with traditional issuance-weighted global-bond benchmarks in mind, which are skewed toward the world's most indebted developed markets. Instead, he and his team aim to identify value among currencies, sovereign credit, and interest rates in countries with healthy or improving fundamentals that they think the market doesn't appreciate. (This fund may carry a sales load.)

Credit-Sensitive Bond FundsWhile some funds focus on the yield curve--the correlation between bond maturities and yields--others are more focused on credit quality. Typically, lower-rated bond issuers must pay higher yields in order to attract buyers willing to take on added credit risk. Funds that invest a significant portion of assets in high-yield issues may be found in the high-yield, multisector bond, or nontraditional bond fund categories. A list of our analysts' favorites among this group, which includes the funds below, can be found here.

Loomis Sayles Strategic Income (NEFZX): This fund's managers employ a value-driven, credit-intensive approach and are always on the lookout for securities and currencies they believe are undervalued. With the flexibility to build significant stakes in junk bonds, convertibles, foreign currencies, and even equities, this fund is typically one of the most aggressive offerings in Morningstar's multisector bond category. The fund has a strong long-term performance record, although its penchant for credit and currency risk makes it vulnerable during flights to quality. (This fund may carry a sales load.)

Metropolitan West High Yield Bond (MWHYX): Longtime managers Steve Kane and Laird Landmann make big adjustments to this fund's overall portfolio depending on the current stage of the credit cycle and where they find the best bargains. The team's flexible approach and patience with its positioning hasn't yielded such impressive results over the past few years. But over the long term, the team's smart, valuation-driven moves have resulted in strong results.

Short-Term Bond FundsFor fixed-income investors worried about rising interest rates, a short-term bond fund (or even an ultrashort bond fund) is often seen as a safe haven. Yet, as Christine Benz discusses in this article, some short-term bond funds dip into lower-quality issues in an attempt to boost yields, thus courting credit risk. For a list of our analysts' favorite short-term bond funds, click here. It includes the following.

T. Rowe Price Short-Term Bond (PRWBX): When credit markets take a beating, this fund shines; but it tends to lag peers during credit-fueled rallies. A focus on income leads to a portfolio heavy in investment-grade corporates and securitized products, like mortgage- and asset-backed securities, relative to its benchmark.

Vanguard Short-Term Bond Index (VBISX): This fund attempts to mirror the performance of the Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index, targeting short-term, investment-grade government, corporate, and securitized bonds that are denominated in U.S. dollars and weighting its holdings by float-adjusted market capitalization. As a result of this approach, the portfolio skews heavily toward Treasury bonds, which account for about 70% of the portfolio--much greater than the short-term bond category average.