Bond funds for cautious investors

Fidelity introduces 4 targeted products that reduce interest-rate uncertainty.

By TheStreet Staff Jul 5, 2011 2:57PM

By Stan Luxenberg, TheStreet

 

Plenty of investors are worried that interest rates will rise in coming years. That could be bad news for bond funds. When rates rise, bond prices tend to fall. So investors in bond funds can't be sure how much money they will have on any particular date.

 

To help reduce the uncertainty, Fidelity Investments recently introduced four municipal funds that target specific dates, ranging from 2015 to 2021. The funds hold bonds that mature near the target dates. The idea is that shareholders will receive their principal back on the target dates.

 

The funds could be attractive for cautious investors who are saving for specific events. Say you will need to make college tuition payments in 10 years. You could invest in Fidelity Municipal Income 2021 (FOCFX).

 

Chances are you will get your principal back on the maturity date, and until then, you receive regular interest payments. In contrast, a conventional municipal fund could tank the year before the student enters college, leaving the family to scramble for cash. For ETF investors, iShares offers a series of passive target-maturity municipal funds, including iShares 2012 S&P AMT-Free Municipal Series (MUAA).

Should you sell your traditional bond funds and switch to the new target funds? Not necessarily. The traditional funds could produce higher total returns. Consider Fidelity Municipal Income (FHGIX), a conventional mutual fund. During the past ten years, the traditional Fidelity fund returned 4.9% annually, outdoing 94% of its competitors, according to Morningstar.

 

The fund achieved the strong results by actively trading, emphasizing long bonds some years and other times buying shorter issues. The ability to trade gives the traditional fund an advantage over Fidelity's target-maturity funds. Those don't have much flexibility to outperform because they must hold only bonds that mature in the same year. Still, a target fund could be the better choice for someone who absolutely needs a fixed amount of money on a particular date.

 

The future total returns of the iShares funds should be fairly predictable. During their terms, the target-maturity funds should deliver total returns that are about equal to their yields. The yield on iShares 2017 is 2.35%, and the total return is likely to about equal the yield. The final results could vary somewhat for the Fidelity funds.

 

Because the Fidelity funds are actively managed, the portfolio managers aim to buy undervalued bonds. Say rates rise next year and investors pour more money into the fund. The portfolio managers could buy more bonds that will mature in 2021. The new issues could come with higher yields and boost the average yield of the portfolio, possibly improving the total return that investors would experience during the fund's lifetime.

 

Instead of buying the target funds, some investors may prefer holding individual bonds. If you buy one bond, you can pick an issue that matures on a precise month. But many investors should prefer the target funds because they offer broad diversification.

The iShares 2012 fund holds 180 securities. Few do-it-yourself investors can afford to buy so many different names. Another advantage of the funds is that they are easy to trade. An investor who needs cash can sell an ETF at any time at a publicly disclosed price. Trading individual bonds can be difficult, and individuals who sell a small amount of bonds can pay stiff fees to brokers.

 

The wide diversification of the funds is particularly important these days because of major shifts in the municipal markets. Before the financial crisis, municipal bonds were largely homogenous. Most bonds were rated AAA because they were covered by insurance. The insured bonds tended to rise and fall in unison.

 

Then, during the downturn, bond insurers sank. Now few bonds carry insurance, and it is hard to find bonds that carry the top rating of AAA. That has made bond shopping more difficult. Investors who formerly picked individual bonds now have good reason to consider using a fund.

 

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1Comment
May 25, 2012 8:40PM
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pork bellies ...that's whar  the smart money is going....and dont ferget rutabeggars and tommater futures and options ...
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