Hedging Your Bets in Bonds

For most of your investing life, you've heard about the importance of diversification. Key words of advice have likely been: "Pay close attention to your stock/bond allocation," "Don't hold too much stock in one company," or "Be sure to include a strong helping of foreign stocks in your portfolio." All of these have become conventional wisdom for newbie investors, and with good reason.

Yet while a great deal of attention is paid to diversification in equities, far less is paid to diversification in bonds. This is a particularly apt time to talk about bond diversification given the enormous flows into bonds ($177.5 billion in taxable and municipal-bond funds during the past year alone) and ongoing concerns about interest rates and how a potential rise in rates would affect the prices of existing bonds.

Although a solid core bond fund such as  Dodge & Cox Income (DODIX) provides a good foundation for diversification from stocks, by adding other, more specialized bond funds to your portfolio, you can capture a broader swath of the fixed-income market while reducing risk in case your core bond holdings take a hit.

One obvious example of bond diversification is foreign bonds, which provide geographic diversification as well as potentially some protection from interest-rate fluctuations here in the United States. Emerging-markets bonds, to cite an example, have a low level of correlation with the Barclays Capital Aggregate Bond Index, which tracks the U.S. investment-grade bond market, but are also much more volatile. Another example is Treasury Inflation-Protected Securities, which provide a hedge against inflation (though not from interest-rate risk), something conventional bonds don't offer.

In keeping with our Alternatives & Diversifiers Week, we decided to use Morningstar's  Premium Fund Screener to look for noncore bond funds our analysts like that might make good diversifiers for your portfolio. We screened on bond funds that the analysts have designated as "supporting players" or "specialty" holdings, meaning they're best used to complement core holdings. We winnowed down the group further by screening for those funds with Morningstar Analyst Ratings of Gold or Silver and minimum investments of $10,000 or less. To see the full screen, available only to Premium members, click  here. Below are a few examples of funds that fit the bill.

 PIMCO Diversified Income (PDVAX) (
)This hedged multisector fund uses a benchmark that is divided into thirds among indexes tracking global investment-grade, global high-yield, and emerging-markets bonds, over- or underweighting sectors as its managers see fit. In 2011, the fund's managers favored shorter-term debt relative to the indexes it tracks. This caused it to miss out on last year's rally in Treasuries and to lag its internal benchmark by 78 basis points. Despite this, the fund finished in the top third among multisector bond funds last year, and its three- and five-year performances, with annualized returns of 17.8% and 7.3%, respectively, are impressive relative to other multisector bond funds. The A shares carry a sales charge and fairly high ongoing expenses, though 401(k) investors might be able to obtain exposure to the cheaper institutional share class.

 T. Rowe Price Short-Term Bond (PRWBX) (
)By playing it safe, this fund has kept volatility low while achieving solid, if unspectacular, results. Slightly more than half the fund's holdings are rated AAA, and nearly all are BBB or better, providing a somewhat higher-quality credit profile than the category average. Average duration, a measure of interest-rate sensitivity, is 1.6 years. The fund has an underweighting in government bonds, at just 4.3% of assets. Although the fund's 4.1% annualized return in the trailing-three-year period lags that of its peers by more than a full point, its five-year annualized return of 4% beats that of other short-term bond funds by about half a point. As of November, the fund had lost money in only two out of 187 rolling one-year periods during manager Ted Wiese's tenure. Its 0.54% expense ratio is below-average for the category. For investors nervous about rising interest rates, the fund could be a good addition to a portfolio anchored in intermediate-term bonds.

 Vanguard Inflation Protected Securities (VIPSX) (
)This TIPS fund offers great inflation protection at a low price. Its managers try to find bargains among various inflation-protected-bond maturities. Unlike some peers, this fund sticks with Treasuries rather than dabbling in other bond types to boost returns. Although TIPS have provided strong returns during the past one- and three-year periods, this fund's 10.7% and 8.5% annualized returns in those time periods outpace the category and bond index averages. The fund charges a low 0.2% in fees, which helps it outperform its competitors. As good as the fund's recent performance has been, investors amassing a TIPS position at this time should certainly consider dollar-cost averaging. Like all Treasury bonds, TIPS prices have spiked during the past few years, and TIPS are also quite sensitive to interest-rate changes.  

Portfolio data as of Dec. 31, 2011; performance data as of March 19.