Investing Specialists

Don't Get Burned by Your Bonds

Christine Benz

"If you were recommending model portfolios for retirees today, would you still allocate such a large portion of the portfolios to bond funds?"

I've received variations on this question from several readers over the past few months, and it's an excellent and timely one. The portfolios that I recommended back in the fall, and in the pages of my new book, 30-Minute Money Solutions, earmarked up to two thirds of their assets for bond funds. But it would be hard to call bonds particularly attractive right now.

There's the obvious concern that interest rates are ridiculously low: The SEC (30-day) yield for  Vanguard Total Bond Market Index (VBMFX), which tracks the Barclays US Aggregate Bond Index, was just 3.35% on Tuesday. You'll earn a modestly higher payout from an investment with a higher dose of credit risk:  Vanguard's Intermediate-Term Investment-Grade Bond (VFICX), which has a higher share of corporate bonds than does Vanguard Total Bond Market Index, was yielding 4.2% earlier this week. That's better, but it's not a significant bump-up.

And once you look beyond the here and now, it's not hard to miss the storm clouds on the horizon. An improving economy is a positive in most respects, but it could be problematic for bond investors. If the economy improves, inflation rears its head, and interest rates head up,  bonds, particularly longer-term ones, will see their prices get depressed. And if the Fed doesn't act in time and inflation takes off, higher prices could gobble up every bit of yield that investors are able to earn. As it is right now, bond investors are barely out-earning today's meager inflation rates. If you think rates and/or inflation will stay down for the foreseeable future, it's important to recognize what a very gloomy bet you're making.

Here Come the Performance-Chasers
These concerns haven't, unfortunately, stopped the mad stampede into bond funds. Through November, open-end bond mutual funds (both taxable and muni) had raked in $320 billion in new investor assets. Fixed-income exchange-traded funds, meanwhile, brought in another $35 billion in the year's first 11 months. Flows into equity funds, by contrast, were roughly flat for both traditional mutual funds and ETFs in 2009.

Some of the investors who have recently invested in bond funds may be simply using the rearview mirror to drive the car--a classic (OK, maybe the classic) investing error. Amid a searing economic environment and a stock market in which the S&P 500 lost nearly 40% of its value in 2008, many investors seem to be betting that smaller but knowable gains are better than the higher-risk/higher-reward profile of stocks.

To those who are simply glomming on to a higher bond weighting because of their outperformance over the past decade, I have one word for you: Don't. Instead, check out  Pat Dorsey's video on this topic.

Just Trying to Do the Right Thing
But what if you're not a performance-chasing market-timer? What if you're simply a well-intentioned investor who has determined that bonds should be X% of your portfolio's long-term allocation and your portfolio is currently below that level? Should you plow your money into bonds, batten down the hatches, and hope for the best?

That's the approach that strategic (i.e., long term and hands-off) asset allocators would advocate. They'd argue that the long-term benefits of a well-constructed long-term portfolio allocation dramatically outweigh any short-term performance hiccups due to poorly timed implementation. One other point in favor of the long-term, strategic approach: Most investors, both professional and amateurs alike, haven't historically shown a lot of skill with tactical timing maneuvers.

At the same time, it's hard to put blinders on to the current environment. And I'm not sure you have to. If you've determined that your portfolio needs more bonds now, there are ways to complete your allocation. Here are a few concrete ideas:

Delegate: There's a reason we recommend flexible, go-anywhere intermediate-term bond funds like  Harbor Bond (HABDX),  Dodge & Cox Income (DODIX), and  Metropolitan West Total Return Bond (MWTRX) for the core of investors' fixed-income portfolios. Their managers can graze across all of the major bond-market sectors, and they can also give their portfolios a more defensive cast if they deem it appropriate. The funds certainly wouldn't be immune in a sustained period of rising interest rates--all three lost money in rising-rate years like 1994 and 1999, for example. But they would at least be able to avail themselves of wide-open tool kits and deep and seasoned teams of analysts.

Investors might also consider devoting a small sleeve of their bond portfolios to a multisector bond. These funds often court a fair amount of risk--many invest in emerging markets and junk bonds, for example--but their flexibility is attractive. The team at  Loomis Sayles Bond (LSBRX), one of  our multisector bond Fund Analyst Picks, recently took home our Fixed-Income Fund Manager of the Year award.

Stay short(ish): Yes, the interest rates on short-term bonds are meager. The SEC yield of  Vanguard Short-Term Bond Index (VBISX) was just 1.5% as of early January, a pitiful percentage for those looking to their portfolios for current income. But the bond portion of your investments is there to provide safety and stability more than it is for return potential. And if you're concerned about the effect that rising rates could have on your portfolio, particularly the portion of it that you expect to draw upon within the next five years, limiting its interest-rate sensitivity is a worthwhile precaution. Morningstar's  short-term Fund Analyst Picks are a good place to start.

Beware of so-called safe investments: Safety may not be all that safe. If you'd like to protect your portfolio from prospective problem spots in the bond market, John Rekenthaler's recent article is required reading. Curiously, some of the most overheated areas, in Rekenthaler's view, are securities backed by the full faith and credit of the U.S. government: Treasury bonds, GNMA mortgages, and five-year Treasury Inflation-Protected Securities. That doesn't mean you need to scrub your portfolio of all traces of these securities, but it is an argument for thinking twice before layering on dedicated exposure to any of these asset classes. (It's also one reason that our analysts are currently lukewarm on total bond market index funds, which tend to be heavy on Treasury and U.S. government-agency-backed bonds.)

Look to high-yielding stocks, but only on a very limited basis: Some pundits, including PIMCO's Bill Gross, have argued that investors may be better off allocating at least a portion of their fixed-income portfolios to dividend-paying stocks. (Gross' specific recommendations were utilities and telecom stocks.) That's not completely unreasonable: Stock dividend yields, in some cases, are competitive with what you'd earn on a bond fund, the stocks have more appreciation potential, and the tax treatment is certainly better. (Dividends are taxed at capital gains rates, at least through this year, whereas bond income is taxed as ordinary income.) But the risk level of dividend-paying stocks is appreciably higher than it is for bonds, as Jason Zweig astutely noted last month, so the asset classes aren't interchangeable. If you peel off a portion of your bond allocation and put it in a dividend-paying stock fund, do so on a very limited basis--say, 5 percentage points of your fixed-income portfolio.

See More Articles by Christine Benz

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.