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By Eric Jacobson | 12-14-10 | 03:30 PM | Email Article

Predicting, parsing, and understanding the behavior of the intermediate-term bond category is as tricky as it's ever been.

On a macro level, that owes to the uncertain future path of the U.S. economy and financial markets. Current Treasury yields imply very modest growth and only modestly higher future interest rates and bond yields; but a wide swath of investors are fearful that yawning deficits, rock-bottom short-term Fed policy rates, and now money-printing associated with large Fed purchases of longer-term bonds will all conspire to ignite a massive sell-off of U.S. Treasury bonds and eventually other domestic-debt sectors.

Eric Jacobson is a senior analyst covering active strategies on Morningstar’s manager research team.

Whatever blanket comments one might have once been able to make about how intermediate-bond funds would generally react in either scenario, however, would be ill-advised today. One reason is that more managers than usual appear willing to sharply change their portfolios' interest-rate sensitivities should a rising-rate bear market look imminent. Another is that a large swath of managers are already taking less-direct action--in part to try to immunize themselves from such events and in part as a residual of opportunistic bets that followed the 2008 crisis and market sell-offs. While many such funds historically ran with a very benchmark-centric focus on the sectors of the Barclays U.S. Aggregate, more allocations to underrepresented or completely out-of-benchmark sectors today mean that many only loosely resemble that bogy. The former often include commercial mortgage securities, while the latter may comprise meaningful exposure to high-yield, nonagency mortgages, or even foreign-currency-denominated debt. Meanwhile, to the degree that a fund does have a large allocation to long-maturity foreign-currency bonds, its reported interest-rate sensitivity, as measured by duration, may not be as relevant to the U.S. market.

On the other hand, the index itself has become more homogenous with a spike in Treasury issuance and the fact that Fannie Mae and Freddie Mac mortgages are now essentially government-guaranteed. Corporates thus make up an even smaller slice of the index, which otherwise has no foreign-currency bonds, nonagency mortgages, or high-yield issues.

These leanings haven't been large enough to cause a mass shift of funds out of intermediate bond into other categories. But they have made the benchmark less relevant over the past few years and have made sifting among this group's funds all the more challenging.

Favorite: Dodge & Cox Income 
Morningstar Rating: 4 Stars
Year-to-Date Return: 6.64%
Expense Ratio: 0.43%

This fund has booked several great years, including 2002, when its management team won Morningstar's Fixed-Income Manager of the Year award. The fund gets a head start from low expenses, proving that you don't have to pay big bucks for good, active management. It's not as cheap as a Vanguard offering, but its expenses are among the lowest in the category. The fund's emphasis on government and high-quality corporate bonds has produced consistently competitive results, and its low-turnover approach has minimized volatility. Click here for the full  Analyst Report.

Favorite: Fidelity Total Bond 
Morningstar Rating: 4 Stars
Year-to-Date Return: 7.8%
Expense Ratio: 0.45%

This fund takes advantage of Fidelity's broad bond-market capabilities by owning small stakes in high-yield and emerging-markets debt. Those riskier areas of the market were arguably overpriced in 2007, and the fund did stumble a bit in that year and 2008. But as the fund's top-quartile 2009 returns displayed, these riskier sectors should provide extra yield and return over the long term. Click here for the full  Analyst Report.

Favorite: Harbor Bond 
Morningstar Rating: 5 Stars
Year-to-Date Return: 7.2%
Expense Ratio: 0.57%

Bill Gross, named Fixed-Income Manager of the Decade for 2000-09 and Fixed-Income Manager of the Year in 1998, 2000, and 2007, has made this fund a star. Gross has driven the fund's returns with timely macroeconomic and sector calls. And although he shies away from most risky bets and sticks primarily to high-quality bonds, this fund has one of the best records in the intermediate-term bond category. Click here for the full  Analyst Report.

Favorite: Metropolitan West Total Return Bond 
Morningstar Rating: 5 Stars
Year-to-Date Return: 10.9%
Expense Ratio: 0.65%

The team here sports some of the best brains in the industry, as well as a solid, deep bench of sector specialists. And although the fund isn't as cheap as Dodge & Cox Income or Vanguard Total Bond Market Index, its 0.65% expense ratio is quite reasonable. The fund's willingness to own large stakes in unloved bonds sometimes gives it a riskier profile than some competitors, but it has compensated with a stellar long-term record. The management team here won the Fixed-Income Manager of the Year award for 2005. Click here for the full  Analyst Report.

Favorite: Vanguard Total Bond Market Index 
Morningstar Rating: 3 stars
Year-to-Date Return: 5.8%
Expense Ratio: 0.22%

This fund is not flashy, but it doesn't need to be. Its superlow expenses make it tough to beat over any extended period of time. It's a terrific choice for a core holding. Click here for the full  Analyst Report.

Red Flag: AssetMark Core Plus Fixed Income Plus 
Morningstar Rating: 3 Stars
Year-to-Date Return: 7.64%
Expense Ratio: 1.25%

This fund's subadvisors--Goldman Sachs and Barrow, Hanley, Mewhinney & Strauss--may not be bad, but they have to be superhuman to overcome this fund's high expense ratio over the long term.

 

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Eric Jacobson does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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