If you need help with your fixed-income allocation, our findings on target-date vehicles and indexes can provide a baseline.
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By Christine Benz | 03-21-12 | 06:00 AM | Email Article

"We spend a multitude of time making sure we get our equity mixes right, adding noncorrelating asset classes, hedges, and other lesser-followed asset classes to achieve the optimal equity mix. With the current low-interest-rate environment for core fixed income, this same approach to the entire fixed-income asset class seems entirely necessary."

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Morningstar.com Discuss boards poster Daltimont made that astute observation in a past Discuss forum thread about setting fixed-income allocations, and I suspect he speaks for the many bond investors who are attempting to find their way in a challenging fixed-income environment. The trouble is bond investors don't have the same tools for setting and benchmarking their exposures that equity investors do.

Total bond market indexes might seem like a logical starting point. But in contrast with total stock market indexes, the Barclays Aggregate Bond Index doesn't include exposure to some important parts of the bond market, especially Treasury Inflation-Protected Securities and junk bonds. Moreover, with ultralow Treasury yields and the high interest-rate sensitivity accompanying government bonds, many market watchers have been questioning whether mirroring the Barclays Aggregate's Treasury-heavy exposure is a wise strategy at this juncture. 

I've tackled how to set your exposure to fixed-income asset classes on a one-off basis in the past. For example, this article talks about setting your portfolio's exposure to TIPS if you're retired, and this one discusses setting exposures to foreign bonds. But how do all of these smaller slices fit together into a cohesive portfolio? And how might intra-fixed-income allocations be different for investors at different life stages?   

To help draw some conclusions, I sampled a range of different resources, ranging from mutual fund category averages to Morningstar's Lifetime Allocation Indexes. Although these resources show that there's a broad divergence of opinion on how much to sink into the main fixed-income asset classes, they help harness the collective research that institutions have sunk into setting bond allocations for their products.

Government Bonds
More than any other bond sector, exposure to government bonds varies widely. In general, the more a product or index is geared to retirees or those in the late-accumulation phase, the more likely it is to be heavy on government bonds. For example, in Morningstar's retirement income category, which consists of one-stop funds for people already in retirement, the typical government-bond weighting is well more than one fourth of the bond portfolio.  

Yet government-bond exposure is lower in vehicles not explicitly geared toward people nearing or in retirement. For example, the typical fund in Morningstar's intermediate-term bond category--consisting of many funds that have broad latitude to range across fixed-income sectors--has 20% in government bonds. Morningstar's target-date categories for early accumulators (for example, those retiring in 2045) have even smaller stakes in government bonds; those stakes progressively increase in target-date categories geared toward people who are closer to retirement.

Why is government exposure generally lower for accumulators than it is for retirees and soon-to-be retirees? As I discussed in this article, it's because retired people typically shift their emphasis from growing their capital--the goal of their accumulation years--to preserving it. Although government bonds are sensitive to interest-rate changes, they're generally more resilient than corporate and mortgage-backed bonds during economic and market shocks. (Government bonds can also be more vulnerable to interest-rate shocks than is the case with other bond market sectors, which is why most retirement-oriented portfolios shorten up interest-rate sensitivity at the same time they add to government bonds.)

TIPS are a subasset class of government bonds, but they merit a separate discussion because they can be such a large component of fixed-income portfolios, especially for retirees. For example, the typical fund in Morningstar's retirement-income category stakes more than 20% of its bond portfolio in TIPS, while Morningstar's Lifetime Allocation indexes geared toward retirees typically hold anywhere from 20% to 40% of their bond positions in TIPS.

Meanwhile, TIPS consume relatively smaller positions in target-date vehicles geared toward accumulators. For target-date funds geared toward people retiring between 2041 and 2045, for example, just a tiny piece of the overall fixed-income position is in TIPS. Within Morningstar's Lifetime Allocation indexes, the moderate version for someone retiring in 2045 doesn't hold TIPS at all.

The difference owes to the fact that working people typically receive cost-of-living adjustments over time, whereas retired people might only receive an inflation adjustment on part of their income, such as the amount they receive from Social Security. That makes it important to add inflation protection at the portfolio level. 
Securities mentioned in this article



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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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Morningstar - 2012/03/21 - Guidelines for Your Bond Weightings - <a href="http://www.morningstar.com/articles/author/30-christine-benz.aspx">Christine Benz</a>
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