Navigate an Uncertain Bond Market

Rachel Haig: I'm Rachel Haig from Morningstar.com. I'm here with Morningstar's director of personal finance, Christine Benz, who recently wrote an article about looming threats in the bond market and what investors can do about them. Thanks for joining me, Christine.

Christine Benz: Rachel, nice to be here.

Haig: A lot of people have been rushing into the bond market. Especially with what happened in 2008, bonds were looking attractive. But now they're looking like they might be a little overheated, with potential increases in interest rates coming. For people who are retiring soon and need a certain bond allocation, what are they to do?

Benz: You're right, it's a tremendous conundrum right now, because people who are nearing retirement or in retirement do need bonds' stability and protection. A couple of ideas I would throw out there. One thing you might do is delegate a portion or all of your fixed income portfolio to an active manager. A couple of funds I like, good core active funds, would be Harbor Bond, which is a clone of PIMCO Total Return; Dodge and Cox Income; MetWest Total Return bond.

These are real opportunistic funds, and so they can go where they think the bargains are, or avoid the problem spots in the bond markets. So that's one idea for the core of a fixed-income portfolio.

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Another idea would be to shorten up the overall portfolio, so intermediate and longer term bonds are going to be the most vulnerable in a rising rate environment. Maybe devote a higher than normal share of your portfolio to shorter term bonds and bond funds.

One I particularly like is T. Rowe Price Short Term bond, it's a corporate-heavy short-term bond fund.

Haig: It sounds like for people who are nearing retirement, it's not so much about severely reducing their percentage in bonds, but maybe it's a case for active management.

Benz: Changing around the allocation a little bit and avoiding those areas that are likely to be particularly hard hit in a rising rate environment. So one area would be the Treasury bond space, tends to react very quickly and negatively to rises in interest rates. That might be an area of your portfolio you want to think about downplaying right now.

Haig: What about for people who have a little bit more time, say 10 to 15 years until retirement? Should they think about reducing their percentage they have in bonds?

Benz: Possibly. And the fact is everyone who is near retirement or even in retirement does need an equity allocation. But the good news for that group is that even though higher interest rates may cause some short-term volatility in the bond market, ultimately that's going to translate into higher yields that are available for the bond portion of your portfolio. But you might consider if you are, say, 10 years out until retirement, you might consider retaining a higher equity weighting. Not going crazy, but stepping it up a little bit to downplay some of the troubles in the bond market.

You might also consider steering a sleeve of what you might otherwise dedicate to fixed income to, say, a high dividend paying strategy. One fund I like in this realm would be T. Rowe Price Equity Income or Vanguard Dividend Growth.

Haig: OK. And then traditionally the idea of bonds and making them an increasing part of your allocation as you near retirement is to reduce the volatility of your portfolio. Do you think that bonds will still serve that purpose, to reduce the volatility? And is this a question seeing reduced yield or seeing real potential for loss?

Benz: If interest rates trend up over a sustained period of time, that could translate into losses for bond funds. But thing I would keep in mind is that the magnitude of those losses would be much less than you would be apt to see in a period of declining stock market. So while there are risks, I wouldn't get too carried away, too worried about the risks. I think retirees and pre-retirees still need to be dedicating a sizable share of their portfolio to fixed income.

Haig: All right. Thanks for the pointers.

Benz: Thanks, Rachel.

Haig: For Morningstar.com, I'm Rachel Haig.