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What to Do with Poorly Performing Bond Funds

Keep them, but consider rebalancing gently into corporates and convertibles.

John Coumarianos, 11/04/2008

Bonds are not perfect investments. They give a fixed rate of return that often barely keeps up with inflation over the longer haul, and they can go down if interest rates go up. They tend to hold up when stocks decline, but even that isn't a bankable certainty. High-quality corporate bonds, for example, may not hold up in a stock market decline or amid financial panic if their prices have been previously bid up by yield-hungry investors in a low-yield environment.

This last phenomenon is exactly what has happened recently. As painful as it has been to see the S&P 500 Index drop nearly 40% this year, some investors have suffered inordinately because the non-stock parts of their portfolios haven't held up well either. Basically, most bond categories except for U.S. Treasuries (where investors flee when gripped by fear) are also off for the year too, making this an extremely treacherous market for even the most well-diversified investors. The Morningstar intermediate-term bond-fund category, for example, is down 6.5% for 2008 through late October, while the Morningstar Intermediate Corporate Bond Index is down 8.7%.

Still, everyone needs some bonds in their portfolio because they often do hold up well when stocks don't. Usually, bonds provide ballast in your portfolio, helping you stick with your stocks when the going gets tough. This was certainly the case in the stock market decline from 2000 through 2002, when bonds held up splendidly and saved well-diversified investors a great deal of pain. Bonds must be part of every investor's asset-allocation strategy--and given how volatile stocks are, they should be a major part of most retirees' strategies.

Moreover, corporate bonds appear cheap now to many managers we've spoken to.

What Now?
Bond aficionados like to talk about "spreads" or the difference between the yields on different kinds of bonds. Typically, they'll talk about the spread between Treasuries and high-quality corporates or Treasuries and high-yield (low-quality or "junk") corporates. In recent years, spreads have been narrow, to say the least. So, if you've owned corporate bonds over the past few years, they've probably paid you only a little bit more than Treasuries.

Now, however, investors are demanding to be paid more for the risk they're taking by owning corporate bonds, as the fear increases that a recession may hamper firms from making good on money investors have loaned them. Because investors can't change the coupons or prearranged fixed payments on existing corporate bonds, investors are selling out of them or lowering the prices. This makes the fixed yield a larger percentage of the new lower price.

However, precisely because investors are selling out of corporates and lowering prices, we think it's time to rebalance the bond piece of your portfolio by shifting a bit out of Treasuries and into corporates.

The good news is that if you're in a good intermediate bond fund, which should be the core of most bond portfolios, you can leave this gentle switching to the manager. Intermediate bond funds generally have a mixture of governments, mortgages, and corporates. If you're looking for a good core bond fund that holds a mixture of a variety of bonds, start with our Analyst Picks list. Consider fees, which are hugely important for bonds, manager tenure, and how the fund generally deals with the two main types of bond risk: interest-rate risk and credit risk. Our analyst reports will have plenty to say about those things.

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