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Bond playbook for 2014

Here's how to invest in bonds next year, including seven funds and ETFs to consider.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 12/26/2013
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Bond investors hoping for a strong 2014 may have to brace for another challenging year.

Rising interest rates have pressured bond prices in 2013 and many analysts expect that trend to continue next year if, as expected, the Federal Reserve reduces its purchases of Treasurys and mortgage securities in coming months. (Bond prices and yields move in opposite directions).

So far this year, the yield on the benchmark 10-year Treasury note has surged from 1.9% to roughly 3%. That has pressured prices across the bond world, saddling the Barclays U.S. Aggregate Bond Index with a loss of about 1.8% in price this year. If the Fed tapers as anticipated, the 10-year Treasury yield is likely to keep rising, reaching 3.5% by the end of 2014 and putting more pressure on bond prices, according to Thomas DeMarco, a fixed-income strategist with Fidelity Capital Markets.

But while higher rates may be a headwind, investors can still make money in bonds — provided they invest strategically and protect their portfolios against interest-rate risk.

"The most important advice we're giving clients is that 2014 will be another tough year for the fixed-income markets and you need to be vigilant," says Andrew Rand, managing director of Rand & Associates, a San Francisco financial adviser.

Bond funds and ETFs for 2014 Expense ratio 30-day SEC yield
DoubleLine Core Fixed Income Fund (DLFNX) 0.76% 4.2%
Fidelity Total Bond Fund (FTBFX) 0.45 2.8
PIMCO Income Fund (PONDX) 0.79 3.7
Wells Fargo Advantage Intermediate Tax/AMT-Free Fund (SIMBX) 0.83 2.2
iShares Floating Rate Bond ETF (FLOT) 0.20 0.30
SPDR Barclays Short Term High Yield Bond ETF (SJNK) 0.40 4.8
SPDR Barclays Short Term Corporate Bond ETF (SCPB) 0.12 0.82

Data source: Fidelity.com 

Stay short and sidestep the Fed

How much to invest in bonds depends on your income needs, investment mix and a host of other factors. For a long-term, moderate-risk portfolio, Rand suggests holding 30% in bonds and 70% stocks. You should consult an adviser or do your own research to figure out the best mix for you.

At a broad level, DeMarco recommends taking credit risk and avoiding interest-rate risk. That means sticking with short-term corporate bonds and minimizing exposure to areas where the Fed may be selling or scaling back its bond purchases, such as Treasurys, agency-backed mortgage securities and TIPS. With less Fed support in those parts of the market, yields are likely to head higher (interest-rate risk), pressuring bond prices.

Yet the central bank is expected to hold short-term rates near zero until at least late 2015. That should "anchor" short-term bond yields, DeMarco says, allowing those bonds to hold "most of their value."

Rand also recommends short-term corporate bonds and uses the SPDR Barclays Short-term Corporate Bond ETF (SCPB) for his clients. The fund is "extremely diversified," he says, and much less sensitive to rates than the Barclays U.S. Aggregate Bond Index.

The downside: The ETF yields just 0.88% and may not generate much real return after inflation.

To reap more income, Rand suggests high-yield corporate bonds and bank loan funds. High-yield, or junk bonds, are less sensitive to interest rates than Treasurys, and the bonds should fare well in 2014 as long as the economy keeps growing, he adds.

For high-yield exposure, he uses the SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK). The ETF yields 4.8% and holds bonds with an average maturity of 3.5 years, lessening interest-rate risk.

The downside: The ETF may be more volatile than a traditional bond fund. An increase in junk bond default rates would pressure the fund's share price.

Bank loan funds can also protect against rising rates. Typically issued to companies with weak credit ratings, the loans usually come with adjustable "floating rates" that tend to rise as rates increase. Rand uses an ETF in this space as well: the iShares Floating Rate Bond ETF (FLOT).

The ETF has returned around 0.6% this year, beating the broad bond market. While it only yields 0.5%, it should be a strong performer if rates continue to rise, says Rand.

The downside: Bank loan funds can be volatile and the ETF would lose money if the loan market slumps.

Total return funds

Some actively managed bond funds take a go-anywhere approach, investing wherever they see the best opportunities. Managers of these funds have the flexibility to underweight government bonds, which tend to have the most interest-rate risk, and many are now emphasizing corporate debt, commercial mortgage-backed securities and other "credit" investments.

The idea? Outperform the market, as measured by the Barclays U.S. Aggregate Bond Index, and generate higher total returns in a rising-rate climate. Some top-ranked funds, according to Morningstar, include DoubleLine Core Fixed Income Fund (DLFNX), Fidelity Total Bond Fund (FTBFX) and PIMCO Income Fund (PONDX). Each fund is broadly diversified and ranks in the top 25% of its category over the last three years, Morningstar says.

Key risks: The funds can be volatile and may be riskier than plain-vanilla short-term bond funds.

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Need more inspiration? Read the latest from the best financial journalists.

Municipal Bonds

Muni bonds have slumped with the broader bond market this year, but these tax-exempt bonds may offer good value going forward, says Fidelity's DeMarco.

According to his research, muni bonds now rank second (behind Russia) out of 25 global fixed-income categories in offering the most attractive yields, adjusted for a top 43.4% federal tax rate on investment income, among other factors.

Munis may even be more compelling than junk bonds, which don't offer tax breaks and can be riskier. After adjusting for defaults and other factors, he says, "a high-yield investor today would receive roughly the same yield as a muni investor, without the tax benefit."

Granted, not all munis are bargains. Investors have flocked to short-term munis, making them "exceedingly expensive," DeMarco says. Longer-term municipals look cheaper. But they're more sensitive to interest rates, and the bonds could slump if rates spike.

Intermediate-term funds offer a middle ground, taking modest interest-rate risk while offering compelling yields for investors in the highest tax brackets.

One top-ranked fund to consider: Wells Fargo Advantage Intermediate Tax/AMT-Free Fund (SIMBX).

Run by two veteran managers, the fund mainly holds investment-grade munis, though it does venture into munis with lower credit ratings. Over the past five years, it's beaten 80% of rivals, according to Morningstar, and outperformed 96% over the past decade. "There's a lot to like in this fund's approach," noted Morningstar analyst Sarah Bush in a report on the fund.

The downside: Higher rates could saddle the fund with losses. Its returns may be more volatile than a short-term fund. Investors should compare the fund's yield on an after-tax basis against taxable bond funds to see if the muni fund makes sense for their financial situation.


Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article

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