Mutual Funds
5 bond funds to survive market hell
How to pick the perfect bond fund: Here are good picks for five flavors of funds from tame to wild.
July 1, 2002: 6:27 PM EDT
By Martine Costello, CNN/Money Staff Writer

This article was first published April 12 but was revised with updated figures through June 30.

NEW YORK (CNN/Money) -- Welcome to investor hell.

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Just a few months ago, it seemed we were out of the woods, but then the other shoe dropped in the form of WorldCom, Xerox, and all the other scandals that are making investors nervous.

All right, you say, I'll do the bond thing (bonds seem at least a little safer, anyway). But it's complicated enough to figure out how they work -- let alone what type of bond to buy. Fact is, most people are clueless about how to find the perfect bond fund. Here's some help.

Finding the perfect bond fund

When you're searching for a perfect bond fund, it doesn't matter as much what type of investor you are as it does what type of portfolio you have, said Eric Jacobson, a bond fund analyst at Morningstar:

* If you have a portfolio that's mostly stocks, with, say, only 5 or 10 percent in bonds, choose an intermediate-term bond fund. Simply put, the longer the term of the bond, the riskier it is. Similarly, short-term bond funds are safer but have tamer returns.

Middle-of-the-road intermediate-term bond funds make great core holdings because they invest in a range of government and good-quality corporate bonds. They earned an average of 9.6 percent in 2000 and 7.4 percent last year, including the yield, according to Morningstar.

* If you have a portfolio mostly in bonds, that's when you can branch out and diversify. In this case, you could put some money in a long-term bond fund, which would give you a better return in spite of short-term volatility.

You might also choose a high-yield, or "junk," bond fund, which invests in lower-quality bonds but pays you a better yield for taking on the risk.

You could put some in a short-term bond fund, which is less affected by interest rates. And you might throw in a tax-free muni fund to shield some income from Uncle Sam.

Metropolitan West Total Return Bond, Fremont Bond and FPA New Income

The intermediate-term bond category is so big and filled with stars that Jacobson was hard-pressed to name just one good fund. So here are three funds that Jacobson thinks are no-brainers: Metropolitan West Total Return Bond, Fremont Bond, and FPA New Income.

All three funds have great long-term records -- five-year annualized returns of around 7 percent, including yield. And all three have great managers, too.

Met West has a management team of veterans, while Bill Gross, perhaps the best bond man on Wall Street, heads Fremont (it's the same style as the better-known PIMCO Total Return, but in a less expensive no-load). Both Met West and Fremont make smart interest-rate and sector plays. FPA manager Robert Rodriguez is more unconventional -- he strays from the pack with inflation-indexed bonds and more high yield than his peers -- but has earned strong returns with less volatility.

Intermediate-term bonds have an average trailing 12-month yield of 5 percent as of May 31. On a $10,000 investment, that means you would have earned $500 in income over the past 12 months. (That doesn't include any capital appreciation or losses on your investment.)

Vanguard Long-Term Corporate Bond

Long-term bond funds aren't for everybody, Jacobson readily admits. For one, you're taking on a lot more risk: Who knows where interest rates will be, or how high inflation will be, in 20 or 30 years? So the funds bounce around a lot as interest rates rise and fall.

But in recent years in a cycle of record rate cuts, the category has soared, making them an appealing addition in a broader bond fund portfolio. One sure bet is Vanguard Long-Term Corporate Bond, which earned 11.8 percent in 2000 and 9.6 percent last year, according to Morningstar.

The fund is good for investors looking for income, according to Morningstar: It invests in middle-quality corporate bonds with maturities of 20-to-30 years. The average trailing 12-month yield is about 5.9 percent.

Metropolitan West Low Duration Bond

Short-term bond funds, by contrast, are less affected by Fed actions, so if you're worried about what lies ahead, try Metropolitan West Low Duration.

The funds normally have modest returns but were helped in recent years by falling rates and the economic slowdown.

The Met West fund focuses on corporate bonds and even invests 5-to-10 percent in high-yield, according to Morningstar. Its five-year annualized return is 6.9 percent, and its trailing 12-month yield is 7.1 percent.

Fidelity Spartan Intermediate Muni Income

"Munis," or municipal bonds, are issued by state and local governments and agencies. They typically have a lower yield than taxable bonds. But the good part is interest earned on municipal bonds is exempt from federal taxes, and sometimes from state and local taxes as well, if you live in the state where the bond was issued.

They're a good alternative if you're in the 27 percent tax bracket or above, or you live in a high-tax state such as New York or California, Jacobson said.

Fidelity has become known as a solid muni bond fund shop, and you can't go wrong with Fidelity Spartan Intermediate Muni Income.

The fund has a five-year annualized return of 5.8 percent -- and remember, that's tax-free. The trailing 12-month yield is 4 percent.

(Click here to use CNN/Money's bond yield converter to find out whether muni bonds are right for you. You can compare your after-tax yield on a taxable bond fund with the yield on a muni fund.)

PIMCO High Yield

High-yield bond funds started the year on a positive note, but corporate accounting problems have taken their toll. That said, an economic rebound should help the category. The funds invest in corporate bonds that are below investment grade.

The good thing about high yield bonds is they also can do well when rates are rising -- because that usually means the economy is strengthening as well, Jacobson said.

PIMCO High Yield invests in a slightly higher quality of bond and branches out to other types of bonds, such as mortgage-backed securities, if they look appealing, Jacobson said.

The fund has a five-year annualized return of 3 percent. Its trailing 12-month return is a healthy 8.3 percent, Morningstar said.  Top of page