Yields Without Tears

08/31/2010 1:00 pm EST

Focus: FUNDS

Richard Band

Editor, Profitable Investing

Richard Band, editor of Profitable Investing, finds two bond funds that offer good yields without too much exposure to vulnerable long Treasuries.

Bond yields are now spectacularly low, thanks to the double-dip recession scare that has gripped Wall Street over the summer. One of my favorite indicators, the deviation between the ten-year Treasury yield and its 52-week moving average, fell to -25% on August 19th. That’s in the bottom 1% of all weekly readings over the past 30 years!

Yes, rates could skid a bit further in September and October if economic data continue to weigh in on the soft side. However, we’re close to an important reversal. The benchmark ten-year T-note could easily yield over 3% again by late 2010 or early 2011.

So, how do we earn a decent income from bonds in this low-yield world—without shouldering unnecessary risk?

First, recognize that maturities beyond ten years are a no-no, unless: 1. the bonds carry some kind of step-up feature that allows you to earn a higher yield down the road, or 2. you’re “renting” the bonds for a quick trade rather than planning to keep them for the long haul.

Is it possible to earn more than 3% without going way out on a maturity limb? Yes. Here are two bond funds that pay more by focusing on intermediate maturities (typically five to eight years). Granted, the share prices of these funds will fluctuate. Over the next year or two, however, I think you’ll be well rewarded:

Dodge & Cox Income Fund (DODIX) [is] a conservative fund that leans toward higher-quality (A-rated or better) debt.  [It has a low] expense ratio of 43 cents annually per $100 invested. [Its] average “duration” of 3.8 years—a measure of sensitivity to interest rates—is low for an intermediate-term bond fund. [It also has a] consistently superior track record dating back more than 20 years. Current yield: 4%.

DoubleLine Total Return Bond Fund (DLTNX) [is] definitely a racier item, but hear me out. Jeff Gundlach, formerly star bond manager at Trust Company of the West, launched this fund in April. Gundlach is investing heavily in mortgages, a sector he knows inside out. “Total return” means he’s aiming for capital gains, as well as income, from undervalued bonds, including deeply discounted subprime mortgages.

If it were anybody else but Gundlach, I wouldn’t give this fund a prayer. But Jeff is a bear—a pessimist on the economy who builds his strategy on very conservative assumptions. For the June quarter, the fund returned a sparkling 8%, double the Barclays bond index. Ultra-low average duration of two years implies a fast payback of principal. Current yield (hold your hat!): 12%. [It pays] monthly dividends.

Both DODIX and DLTNX are appropriate for income seekers to purchase at today’s levels. [There’s] no sales charge or redemption fee if you buy through the fund sponsor. Additionally, DLTNX is available fee-free through Fidelity, Schwab, and TD Ameritrade.

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