Guidelines for Your Bond Weightings

"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."

Morningstar.com Discuss boards poster Daltimont made that astute observation in a recent 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 was geared to retirees or those in the late-accumulation phase, the more likely it was 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 was 46% of the bond portfolio (roughly in line with that of the Barclays Aggregate Index).  

Yet government-bond exposure was dramatically 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 24% in government bonds. Morningstar's target-date categories for early accumulators (for example, those retiring in 2045) have even smaller stakes in government bonds, though 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
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 23% 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 2% 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. 

Corporate Bonds
The opposite trend is in play for corporate bonds. Specifically, vehicles and indexes geared toward people in retirement typically stake less in corporate bonds than those geared toward accumulators. The typical retirement-income fund, for example, has less than one fourth of its bond assets in corporate bonds.

Target-date funds geared toward early accumulators, by contrast, usually stake far more in corporates. For example, the average target-date vehicle for those retiring between 2036 and 2040 has upward of 40% of its bond portfolio in corporate bonds. The average intermediate-term bond fund lands somewhere in the middle, with roughly one third of its bond assets in the corporate sector.

Foreign Bonds
Foreign-bond weightings tend to be smaller in absolute terms, across vehicle types, than is the case with the aforementioned sectors. However, the trend with foreign bonds is similar to corporates, with higher weightings for long time horizons and smaller weightings for shorter ones. At the aggressive end of the spectrum, the average target-date fund for someone retiring in 2050 or beyond has nearly 19% of its bond assets in foreign bonds, whereas retirement-income vehicles stake less than 10% of their portfolios overseas. Intermediate-term bond funds' weightings fall between these two poles, with average foreign-bond weightings of 14%. This article discusses how to think about your exposure to foreign bonds.

Mortgage-Backed Bonds
While weightings in other bond sectors tend to vary dramatically depending on life stage, there's less variation in exposure to mortgage-backed bonds when you look across vehicles and categories. The average intermediate-term bond fund--as well as Barclays Aggregate Bond Index--holds roughly 30% of its bond assets in mortgage-backed bonds. Funds in Morningstar's retirement-income category have an average of 21% of their fixed-income portfolios in mortgage-backed bonds, as do target-date funds geared toward early accumulators.

Credit-Quality and Interest-Rate Exposures
The preceding has focused primarily on allocations to the key bond sectors rather than credit quality or interest-rate sensitivity. Across categories, however, products aiming to deliver well-diversified fixed-income exposure typically stake a limited amount (less than 5%) in non-investment-grade credits (those rated BB and lower); that exposure doesn't vary substantially with life stage.

Yet interest-rate sensitivity does show a marked decline in products geared toward retirees versus those geared toward younger accumulators. As discussed in this article, accumulators can ride out the bumps that inevitably accompany longer-duration bonds, whereas retirees are typically looking to their fixed-income assets for liquidity and ballast. Thus, Morningstar's Lifetime Allocation Indexes geared toward retirees have their largest positions in intermediate-term and short-term bonds and stake just a small slice in long-term bonds. The indexes geared toward accumulators, meanwhile, have their largest bond positions in long-term bonds, medium-size positions in intermediate-term bonds, and nothing in short-term assets.

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