Investors in even the best bond funds that Wall Street has to offer might be in for a difficult 2020.
Much of the bond market, in my view, is in a bubble - just as tech stocks were in 1999. And bubbles always end badly.
Consider that in November 2019, $12.5 trillion was invested globally in bonds that have negative yields. That's down from a peak of $17 trillion in August, but that's still an absurd amount of money invested globally in bonds that have negative yields. That means investors are paying interest to a borrower to lend the borrower money -- which is just as crazy as it sounds. Carl Weinberg, chief economist at High Frequency Economics, notes that a bond with a negative yield is worth less than "a bag of dirt in your basement."
What's more, at various points recently, long-term bonds have been paying lower yields to investors than short-term bonds - a phenomenon known as a negative yield curve, which is typically predictive of a recession sometime down the road.
The lesson is to keep bond maturities short. With bond yields so low, they almost have to rise unless we're entering a period of serious deflation, which seems a remote possibility. And when bond yields rise, total returns on shorter-duration funds will sparkle compared to likely losses on long-term bond funds.
Here are my seven best bond funds to buy for 2020, from least to most risky. Bonds are primarily intended to add stability and a bit of income to your portfolio - not to take big risks in search of huge profits. For bonds, 2020 likely will be a year to be concerned not so much with return on capital but with return of capital.
T. Rowe Price Short-Term Bond
Market value: $5.5 billion
SEC yield: 2.1%
Expense ratio: 0.44%
T. Rowe Price (TROW) gets lots of attention for its stock funds, many of which are top performers. But some of its best bond funds, including T. Rowe Price Short-Term Bond (PRWBX, $4.73), are just as good.
Piloted over the past five years by Michael Reinartz, this fund takes few chances. It owns a mix of corporate bonds, government issues and securitized bonds with an average credit rating of single-A, which is roughly in the middle of the investment-grade spectrum. Less than 5% of the fund is in high-yielding junk bonds.
Duration is about two years, meaning the fund faces little downside should interest rates rise. Duration is a more accurate measure of a bond fund's interest-rate sensitivity than maturity. In this case, the two-year duration means that if rates climbed one percentage point, PRWBX's net asset value would decline by 2%. (Yields and prices move in opposite directions.)
Don't expect to get rich with T. Rowe Price Short-Term Bond. It has returned an annualized 1.7% over the trailing five- and 10-year periods. But if the market tanks in 2020, this fund will provide much-needed ballast.
Vanguard Short-Term Investment-Grade Investor
Market value: $61.3 billion
SEC yield: 2.2%
Expense ratio: 0.20%
Vanguard Short-Term Investment-Grade Investor (VFSTX, $10.73) offers a low-risk approach to taxable bonds. Duration is just 2.5 years, and the average weighted credit rating, like PRWBX, is single-A.
VFSTX invests mainly in high-quality corporate bonds, which comprise almost two-thirds of the portfolio. Another 24% of the fund is in securitized instruments, mainly mortgages, with most of the rest invested in Treasuries.
Don't let recent manager changes here upset you. While longtime manager Greg Nassour suddenly departed in 2018, Vanguard's time-tested record with bonds inspires confidence. Current managers Samuel Martinez and Daniel Shaykevich previously ran portions of VFSTX's holdings.
Vanguard Short-Term Investment-Grade Investor has retuned an annualized 2.4% over the past half-decade. Its returns through Nov. 18, like so many bond funds, have been stellar, at 5.4% year-to-date.
SEE ALSO: The 5 Best Vanguard Funds for Retirees
Vanguard Limited-Term Tax-Exempt Investor
Market value: $29.1 billion
SEC yield: 1.3%
Expense ratio: 0.17%
Low expense ratios are always a crucial factor in choosing funds. But when you consider how low returns might be on even the best bond funds for 2020, low costs are paramount.
That's why so many Vanguard mutual funds make the cut here.
Vanguard Limited-Term Tax-Exempt Investor (VMLTX, $11.06) is a perfect example. With a meager yield of 1.3% on this municipal-bond portfolio, Vanguard's skinflint expense ratio of just 17 basis points annually (a basis point is one one-hundredth of a percent) presents an enormous hurdle for competitors.
VMLTX defines low risk. It has a high average credit rating of AA and a 2.5-year duration. Keep in mind, too, that municipal bonds are generally much less likely to default than corporate bonds.
Adam Ferguson has run the fund for just two years. But Vanguard's expertise and experience in fixed income, coupled with the fund's low-risk strategy, are noteworthy.
Over the past five years, Vanguard Limited-Term Tax-Exempt Investor has returned an annualized 1.6%. Yes, that's not much, even when you consider the yield from municipal bond funds is exempt from federal income tax. But it's a good holding for a scary bond market like the one we could face in 2020.
Metropolitan West Unconstrained Bond M
Market value: $3.3 billion
SEC yield: 3.7%
Expense ratio: 1.03%
Metropolitan West Unconstrained Bond M (MWCRX, $11.92) is less risky than most "unconstrained" bond funds. (Unconstrained bond funds aren't required to stick to a specific bond index.) Most of the risks MetWest does take are in nonagency mortgages and other securitized fare - an area the managers know extremely well, and one favored by several of the best bond funds for 2020.
Almost two-thirds of MWCRX's assets are invested in securitized instruments. The fund has a duration of just under two years, and credit quality averages a relatively high BBB.
Three of the four managers have run $80 billion Metropolitan West Total Return Bond (MWTRX) - a Kiplinger 25 selection - for more than 20 years. (Total Return has a much longer duration but also overweights mortgages.)
Since inception in 2011, MWCRX has returned an annualized 5.3%. The fund's big successful bet: Mortgages that were once classified as subprime are likely good risks now given that borrowers have paid on them for many years.
Vanguard Intermediate-Term Tax-Exempt Investor
Market value: $71.3 billion
SEC yield: 1.6%
Expense ratio: 0.17%
Suppose my outlook for the bond market is either wrong, or at best, premature. Bond yields could fall next year, or just stay relatively flat. That's why it usually makes sense to own more than one bond fund.
Vanguard Intermediate-Term Tax-Exempt Investor (VWITX, $14.41) should hold up pretty well if rates rise only a small amount in 2020, and it could trounce the other funds in this article if rates fall.
VWITX's duration is 4.9 years. That means if bond yields rise by one percentage point, the fund's price should decline by 4.9%. That wouldn't be fun for investors, but it would hardly be catastrophic, especially when you factor in the yield.
Like most Vanguard bond offerings, Vanguard Intermediate-Term Tax-Exempt Investor is plain vanilla, and that's OK. It sticks almost entirely to high-quality municipal bonds. Its weighted average credit quality is a sterling AA.
VWITX also has been a decent performer, at an annualized 3.1% total return over the past five years.
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DoubleLine Total Return Bond N
Market value: $54.8 billion
SEC yield: 3.2%
Expense ratio: 0.73%
Jeffrey Gundlach was fired by TCW in 2009. Shortly thereafter, he founded DoubleLine and built a bond colossus.
Much of Gundlach's success, with the firm and as lead manager on DoubleLine Total Return Bond N (DLTNX, $10.70), comes from savvy investing in mortgage-backed securities.
DoubleLine's name, by the way, stems from Gundlach's proclivity to take a "barbell" approach to bond investing, which extends to DLTNX. At one end of the barbell are nonagency residential mortgages, which have thrived as the economy has strengthened over the past decade. At the other end are bonds with higher credit quality but with more interest-rate sensitivity.
Overall, DLTNX exhibits an average weighted credit quality of single-A and a duration of 3.6 years.
Admittedly, DoubleLine Total Return Bond was among the top bond funds early on in its existence before tapering off somewhat. Critics argue Gundlach should have closed the fund to new investors so fresh assets wouldn't hinder performance. Still, more recent returns have been decent. Over the past five years, it has returned 3.1% annually on average.
SEE ALSO: The 7 Best New ETFs of 2019
Pimco Income A
Market value: $131.2 billion
SEC yield: 2.8%
Expense ratio: 1.45%*
Want a bond fund that can still produce juicy returns? You won't be able to do it with simple, straightforward funds, such as those offered by Vanguard.
Instead, you'll need to look to a complex creature such as Pimco Income A (PONAX, $11.98), which returned an annualized 4.9% over the past five years. It's also among the best bond funds in its category over the past decade, with 8.3% annualized returns.
Pimco Income, which is among the biggest bond funds by assets under management, invests a big chunk in non-government-backed mortgages. But it also invests in corporate bonds, Treasuries, high-yield junk bonds, foreign developed bonds and emerging markets. It even owns a handful of stocks. Altogether, it owns more than 7,100 bonds and roughly 490 "other" holdings, according to Morningstar.
Where PONAX sticks out from the crowd is that it uses a variety of derivatives to make big bets that some securities will rise and others will fall. It's currently wagering that long-term bonds will fall in price while shorter-term bonds will profit.
Pimco Income's biggest short wager currently is that foreign-developed bonds will fall in price. Fully 30% of the fund's market value was allocated that way at the end of September. Meanwhile, 77% was counting on a rise in prices for securitized assets, such as mortgages. It makes these outsize bets by using leverage (borrowed money).
PONAX reports a duration of just 0.41 years, which means it would lose essentially nothing should interest rates head higher from here.
Just don't fool yourself. This might indeed be one of the best bond funds for 2020 - it's a quality product from a bond manager with a terrific long-term record. But Pimco Income carries significant risks - risks that might only become apparent if and when the managers make a few terrible mistakes on the direction of the bond markets. So feel free to invest in the fund, but don't overdo it.
* A-class shares also includes a 3.75% maximum sales charge that varies based on how much you invest. Other share classes feature different fee structures. For instance, R-class shares, which are available in 401(k) and other retirement plans, do not have initial or contingent deferred sales charges.
Steve Goldberg is an investment adviser in the Washington, D.C., area.
Copyright 2019 The Kiplinger Washington Editors