Bond Funds Are Good Bets Now

05/10/2007 12:00 am EST

Focus: BONDS

Jim Lowell

Partner & Chief Investment Officer, Adviser Investments

Jim Lowell, editor of Jim Lowell’s Fidelity Investor, recommends three Fidelity bond funds he thinks will do well in the current environment of moderating interest rates.

In today’s environment of moderating interest rates, bond fund prices are likely to remain relatively stable, and they’ll continue to accrue their monthly interest. If interest rates fall significantly (not likely), you can look to the longer-term funds to make significant capital gains. If interest rates climb rapidly (not likely), bond funds will show losses in principal, and longer-term funds could have big losses.

I think we’ll see a repeat of the bond fund performance pattern that played out in the first quarter: daily gyrations based on doses of economic data that portend inflationary pressures or recessionary concerns. As a result, we’ll remain positioned as we currently are in [Fidelity bond funds like the following]:

Fidelity Inflation-Protected Bond Fund (FINPX—upgraded to a buy this month), is a kind of government fund, as the inflation-protected debt securities market is pretty much limited to US Treasuries (for now). TIPs bonds’ income is a couple points below that of unadjusted bonds, but their principal is automatically bumped up along with the consumer price index of inflation. The bonds’ inflation protection gives them, under most market conditions, the volatility of a long-term Treasury. They’re susceptible to changes in “real” (on top of inflation) interest rates, but not to inflation. Investors in this fund can expect greater volatility in uncertain times like these, but also likely better results so long as recession’s specter haunts the Fed.

Fidelity’s US Bond Index fund (FBIDX) has, since 1990, tracked the Lehman Brothers Aggregate Bond Index, which includes the full spectrum of bonds (government, agency, mortgage, corporate; of varying maturities) except for junk bonds. The fund has shown a rather low turnover rate relative to its benchmark, and its expense ratio (normally 0.50%) is capped at 0.32%, basically enabling it to best its benchmark index. US Bond Index is basically an institutional fund. Fidelity has been promoting it to retail investors only since late 2001, and now the minimum investment for nonparticipants in institutional retirement plans is $10,000.

Fidelity Strategic Income (FSICX—rated buy) would appear to take on similar risks [as junk bond funds], but has been less volatile with its diversified portfolio of about 40% in junk bonds, 30% in US higher-quality bonds, and 30% divided between foreign established and emerging market debt. While junk bond funds are the riskiest portion of the domestic bond market, they’re still less risky than [most] stock funds. In short, any investor who can afford to take on stock-market risks—and most investors with time horizons over five years should—can afford to take on junk-bond risks.

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