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By Jason Stipp and Christine Benz | 12-20-2012 01:00 PM

Time to Adjust Your Bond Expectations?

Bonds are a better option than cash and less volatile than stocks, but investors should be mindful of headwinds and possibly rethink their fixed-income allocations, says Morningstar's Christine Benz.

Jason Stipp: I'm Jason Stipp for Morningstar. Investors approaching retirement have an interesting dilemma in today's market, just as theoretical asset allocation would tell them to hold more in bonds, we see clouds on the horizon for fixed income. Here to talk about dealing with this situation is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: We're going to talk about some ways you can think about your portfolio and fixed income, but first what are the concerns in fixed income right now? Why are folks so worried about their bonds?

Benz: A couple of key things, Jason. First, is that yields are quite low, so the current yield you get on a total bond market index fund is about 1.5%--that's an SEC yield--so it's based on the previous month's yield sort of extrapolated over a 12-month period. That's very low. So, you're not getting much income from high-quality bonds right now, and that in turn detracts from the other thing you might be looking for your bonds to do, which is to give your portfolios stability. So, when yields are as low as they are now and the markets go down, bonds just don't have that same cushion there to help cushion the losses that they might if yields were lower. So bonds are not scoring well on the stability front or the income front right now.

Stipp: If the income portion isn't really paying me a whole lot, and as you said, there isn't as much cushion there, why would I even look at bonds as an option then? If it's supposed to be fixed income and not paying me income, should I just overlook bonds and put them to the side for the time being?

Benz: It might be tempting, but I would say no. I think, a recent video I did with Bill Bernstein, who is an asset-allocation guru, really spelled out the reason you'd want to make sure that you still do have bonds in your portfolio, and the idea is that it's ballast. So, you've got your equity portfolio and that's kind of your portfolio's return engine. Your long-term returns there are likely to be better than you get from the other asset classes. The bonds are there to stabilize the whole thing, and that bond position does in fact need to become larger as you get closer to needing your money.

So, you need to lock down the assets that you've managed to save and keep money on the side, and I think investors need to remember that even in a rising interest-rate environment, which could push down bond prices, bonds will still be a lot less volatile than will the stock component of their portfolio. People often look to the Large-Cap Value category to be sort of the safe component of their stock portfolio. Even there over the past decade, the standard deviation has been in the range of 15 versus just 4 for the typical intermediate-term bond fund. So, that's a stark difference and it's something that investors really need to keep in mind if they do want to try to offset some of the volatility that will tend to be inherent in their equities.

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