Barron's: Six Top-Notch Bond Funds

THE VOLATILITY OF THE STOCK MARKET has caused many investors to stash their cash in certificates of deposit, money-market funds -- even under the mattress. There's a better alternative: bonds, some of which offer substantial value, and less agita than equity.

The word's getting out. For the first time in five years, a majority of money managers favor bonds over stocks, reports the quarterly Investment Manager Outlook Survey by Russell Investments. The poll was conducted between Feb. 26 and March 6, just prior to the latest equity rally.

Taxable and tax-exempt bond funds enjoyed net inflows of $36.6 billion last year, versus U.S. equity-fund outflows of $93 billion. Mortgage, investment-grade high-yield and municipal bonds got hammered last year -- regardless of quality -- as the credit markets seized up. But liquidity is improving. Bond prices appear to have stabilized; they're still cheap by historical standards. With the Federal Reserve likely to use all of its firepower to keep interest rates low, less-volatile bonds could well outperform equities this year.

Barron's has picked a half dozen top-notch mutual-fund bond specialists that investors should consider. Their managers share three characteristics: They're conservative, savvy and experienced. Here are their thoughts on where the best values are.

THE CO-MANAGERS of the $2.84 billion First Pacific Advisors' FPA New Income Fund avoided last year's train wreck by changing tracks in 2004 and "05, when they began to worry about mortgage delinquencies. As a result, the managers, Robert Rodriquez and Thomas Atteberry, got rid of Alt-A and subprime-mortgage-related securities. The fund (FPNIX) also exited high-yield bonds when the possible rewards no longer seemed to merit the risks. Both moves paid off. FPA had a gain of 4.3% last year, beating the typical intermediate-bond fund by 9 percentage points. The fund loaded up on triple-A-rated Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Bank collateralized mortgage obligations, or CMOs, and pass-throughs (pools of mortgages whose cash flows are the monthly payments made by homeowners).

At the end of 2008, the fund had about 36% of its assets in cash, which it has since cut to about 25%, says Atteberry; "it's nice having cash available when someone has to sell" for redemptions. The fund, which has no sector limits or index benchmark, is up 1% year-to-date through April 1.

Right now, about 42% of his mortgages are older CMOs or pools. That's in part because loans written before 2002-'03 were still subject to tougher lending standards and because a five-year-old, 15-year mortgage with a balance of $100,000 or under has a much lower chance of being refinanced, which would leave the mortgage holder stuck with a lower yield.

Atteberry doesn't like Treasuries. "These are unsustainable [low] interest levels, with rates manipulated by the Fed's buying 30-year" debt, he says, referring to the Fed's plan to buy long-term Treasuries. Right now, outstanding Treasury bonds equal 60% of U.S. gross domestic product. By the end of 2010, they'll be 100%. That's about equal to the debt levels in such shaky economies as Italy, Greece and Sri Lanka.

The fund, which can't have more than 25% of its assets rated below double-A, does come with a couple of caveats. Although it has a low expense ratio of 0.61%, FPA has a front load of 3.50%. And Rodriquez, who's never had an annual loss since taking over the fund in 1984, will take a one-year sabbatical next January. However, Atteberry, who's been with FPA since 1997, is a bond veteran who's expected to keep to the same strategy. The two shared Morningstar's fixed-income manager-of-the-year award for 2008.

The Fidelity Government Income Fund returned an eye-popping 11% in 2008, helped by its holding of U.S. Treasuries, especially longer-dated bonds.

Bill Irving, taxable-bond-portfolio manager at Fidelity, concedes it's "very unlikely we'll be able to repeat that performance" this year. He expects the Fed, which plans to buy $300 billion in Treasuries and $1.25 trillion in mortgages, to keep interest rates in a tight range for the year. The $6.92 billion no-load fund was up 0.49% in 2009 through April 1.

Irving doesn't plan to take big chances. He aims to keep 80% of the fund (FGOVX) in government bonds, FDIC-insured debt, government-guaranteed Ginnie Mae CMOs and pass-throughs, and other agency debt. The fund won't buy riskier assets to chase incremental yield. The Government Income fund, which sports a very low 0.45% expense ratio, is designed to provide "steady income, and is a counterweight to the equity component of a diversified portfolio," says Irving. It certainly played that role convincingly in "08.

MUNICIPAL BONDS, generally considered safe bets that rarely default, got whacked last year as fears spread about state and local governments' ability to repay their debts. By autumn, a double-A-rated bond was yielding 6.80%, which was "insanely cheap," says Joe Deane, manager of Legg Mason Partners Managed Municipals Fund (SHMMX).

Deane didn't sidestep all the problems; his $3.9 billion fund lost 9.3% last year. He has, however, returned 3.62% a year on average over the past 10 years, and has already gained 6.97% this year. (Managed Municipals has a front load of 4.25% and an expense ratio of 0.66%.)

Prices got so low early in 2009 in part because hedge funds sold munis to raise cash for redemptions. "We weren't looking for liquidity," says Deane. "We were providing it." Then bargain hunters jumped in, helping to push yields on double-A tax-exempts back down to 5.30% in February.

Legg Mason was able to mitigate losses by buying a lot of pre-refunded munis last year -- refinanced municipal debt that uses its proceeds to buy Treasuries to be held in escrow, from which they pay interest and principal on the original issues.

After the brief rally, yields have begun to creep back up near 6%, a level Deane finds "very cheap." The portfolio manager, who's been with the fund since 1988, recently has been buying essential services' revenue bonds and general-obligation bonds from states and cities "that have the wherewithal and political will" to balance their budgets. Among them: New York City water bonds.