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The 7 Best Bond Funds to Buy for a Shift in Interest Rates

Kent Thune

Now that the Federal Reserve is moderating its monetary policy, and the yield curve has turned negative for the first time since 2007, the best bond funds to buy are also beginning to shift.

As recently as the third quarter of 2018, it appeared as if the Fed would hike interest rates two or three times in 2019. By the beginning of 2019, the Fed’s tone and outlook began to signal that one or two interest rate bumps during the year were the best bet. As of a few days ago, the Fed indicated it may not raise rates at all in 2019 but may possibly hike rates just once in 2020.

What this means for bonds is that yields will moderate along with the Fed’s policy. Moderating yields will in turn provide support, or even a lift, to bond prices. Translation: Now may be a good time to increase your exposure to bond funds.

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With that backdrop in mind, here are the best bond funds to buy for a shifting interest rate environment:

Best Bond Funds to Buy: iShares Core U.S. Aggregate Bond (AGG)

Best Bond Funds to Buy for a Shifting Interest Rate Environment: iShares Core U.S. Aggregate Bond (AGG)

Expenses: 0.05%, or $5 for every $10,000 invested

Smart investors know, especially after the past year, that the interest rate environment is difficult to predict. This uncertainty makes a broadly diversified bond fund like iShares Core U.S. Aggregate Bond (NYSEARCA:AGG) a wise choice.

AGG tracks the Bloomberg Barclays U.S. Aggregate Bond index, which covers the entire U.S. bond market of more than 7,000 bonds. Although the portfolio has a broad range of maturities and credit quality, the average weighted maturity is just under eight years and the average ratings are investment grade.

This means that investors can reap the benefits of reduced market risk through diversification but also the potential price gains coming for a moderating rate environment.

Vanguard Intermediate-Term Corporate Bond (VCIT)

Best Bond Funds to Buy for a Shifting Interest Rate Environment: Vanguard Intermediate-Term Corporate Bond (VCIT)

Source: Shutterstock

Expenses: 0.07%

As bonds come back into favor, corporate bonds typically outperform Treasury bonds and municipal bonds. This makes Vanguard Intermediate-Term Corporate Bond (NYSE:VCIT) a smart choice now.

Treasury bonds and municipal bonds typically have lower yields than corporate bonds. They also generally have lower annualized returns, especially when investing for longer than one year.

Unless you are investing in a taxable brokerage account and need tax-free income, a low-cost corporate bond fund like VCIT is a great fund to hold now and in the long run.

SPDR Nuveen Barclays Municipal Bond Index (TFI)

Best Bond Funds to Buy for a Shifting Interest Rate Environment: SPDR Nuveen Barclays Municipal Bond Index (TFI)

Expenses: 0.23%

Investors needing tax-free income at the Federal level should consider a low-cost, diversified bond fund like SPDR Nuveen Barclays Municipal Bond Index (NYSE:TFI).

If you want to increase your exposure to bond funds to take advantage of moderating or falling interest rates, you’ll need to be cautious about the tax implications. If you’re investing in a taxable account and your top Federal tax rate is 32% or higher, a municipal bond fund like TFI can be a smart idea.

Although municipal bonds typically have lower yields than corporate bonds, the tax-equivalent yield of municipal bonds (the yield a taxable fund would need in order to equal the tax-free yield of a municipal bond fund) can make sense.

The SEC yield for TFI is a solid 2.1% and the tax-equivalent yield is 3.5%.

PIMCO 25+ Year Zero Coupon U.S. Treasury Index (ZROZ)

Best Bond Funds to Buy for a Shifting Interest Rate Environment: PIMCO 25+ Year Zero Coupon U.S. Treasury Index (ZROZ)

Expenses: 0.15%

If you’re not afraid of taking extra risk, a highly interest-rate-sensitive bond fund like PIMCO 25+ Year Zero Coupon U.S. Treasury Index (NYSEARCA:ZROZ) may be your best bet for out-sized returns.

When interest rates are flattening and expected to fall, the bonds and bond funds with the greatest interest rate sensitivity typically see the biggest price gains. Bonds with long maturities will see bigger price gains than those with shorter maturities. Also zero-coupon bonds have greater interest rate sensitivity  because they pay the investor zero interest until maturity.

Enter ZROZ. This ETF holds long-term zero-coupon bonds and will likely see the biggest jumps in price, assuming the interest rates remain flat and begin to decline in 2020 (or sooner).

Vanguard Total Bond Market Index Admiral Shares (VBTLX)

Vanguard Total Bond Market Index Admiral Shares (VBTLX)

Source: Shutterstock

Expenses: 0.05%
Minimum Investment: $3,000

For a low-cost, diversified bond mutual fund, it’s tough to beat Vanguard Total Bond Market Index Admiral Shares (MUTF:VBTLX).

Vanguard recently closed most of their Investor Shares mutual funds and made their lower-cost Admiral Shares available to investors with the same $3,000 minimum initial investment. This makes many of their mutual funds as cheap as the cheapest ETFs on the market.

To get broad exposure to bonds without taking on too much interest-rate risk, VBTLX is an outstanding choice. The portfolio tracks the Bloomberg Barclays U.S. Aggregate Bond index, which consists of over 7,000 bonds, providing exposure to the entire U.S. bond market.

Vanguard Long-Term Bond Index (VBLTX)

Source: Shutterstock

Expenses: 0.15%
Minimum Investment: $3,000

The best low-cost long-term bond mutual fund is arguably Vanguard Long-Term Bond Index (MUTF:VBLTX).

As the Fed puts a hold on rate hikes, and the potential increases for rate cuts, long-term bond funds like VBLTX can be a smart move. This is because long-term bonds tend to have greater price increases than short- and intermediate-term bonds as interest rates begin to fall.

VBLTX tracks the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index, which consists of more than 2,000 U.S. long-term bonds. In addition to potential for greater gain potential, the 3.8% trailing-12-month yield may be attractive to investors looking for income.

Loomis Sayles Bond Retail (LSBRX)

Bonds

Source: Shutterstock

Expenses: 0.91%

If you’re looking for a well-managed go-anywhere bond fund to compliment your core bond funds, Loomis Sayles Bond Retail (MUTF:LSBRX) can be a fine choice.

The bond market is arguably more complex and more difficult to forecast than the stock market. This makes a solid case for investing in either a passively managed index fund or an actively managed fund with an outstanding manager at the helm. Some investors may choose to have the best of both and use a total market index fund for a core holding and a fund like LSBRX as a compliment.

Diversification is especially important in uncertain interest rate environments, as is the case in 2019.

LSBRX is managed by Dan Fuss, who has been at the helm of the fund for nearly 30 years and has been managing fixed income portfolios for over 50 years. The LSBRX portfolio consists of a wide range of maturities and credit quality. About two-thirds of the bonds are U.S. and the other one-third is non-U.S. bonds.

As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities, although he held AGG and VBTLX in some client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.

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