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Need Bonds Now? 4 Tips to Keep from Getting Pinched

Don't delay derisking, but proceed with caution when enlarging your bond stake.

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When it comes to investor behavior, the biggest head-scratcher during the past couple of years has been ongoing inflows into bond funds. Yields are meager and the threat of rising interest rates looms large, yet that didn't stop investors from plowing more than $100 billion into taxable- and municipal-bond funds in the first quarter of 2012 alone.

Is this yet another example of investors getting caught in the fear/greed cycle and exhibiting terrible timing as a result? There might be an element of that. Although equities have gained 20%, on average, during the past three years, it's likely that some investors are still scarred by what they endured in the recent bear market. They'd rather settle for what they expect will be a low but somewhat knowable return from bonds than risk big equity market losses again. And bonds have still generated better returns than stocks during the past decade.

But there's another explanation for bond-fund inflows that seems equally plausible: demographics. The first baby boomers turned 65 in 2011, and as retirement approaches, they've come to the sensible realization they need to take risk off the table. They need securities that will deliver income and stability as they get close to and enter retirement, and that naturally brings them to bonds.

If you're in that cohort, you might be grappling with what to do. Of course, all situations are different, but here are four concrete strategies you can use to avoid getting burned.

1) Don't delay derisking. 
If you've X-Rayed your portfolio and determined that your equity weighting is extremely aggressive relative to various sources of asset-allocation advice or your own common sense, taking risk off the table is an essential step. For starters, stocks aren't outrageously priced right now, but nor are they exceptionally cheap following a three-year market runup. Higher valuations make periodic market sell-offs more likely, as we've seen in recent months. But more importantly, encountering big stock market losses early in one's retirement years can deliver a crippling blow to an equity-heavy portfolio. If you have to draw assets from your stock holdings in the midst of a market downdraft, that has the net effect of turning paper losses into real ones. As this Vanguard study discusses, retirees who plowed money into cash and bonds as they got older fared much better during bear markets than those who had not systematically derisked their portfolios.

2) Proceed deliberately with new bond purchases.
But just because you need to derisk your portfolio, that doesn't mean you have to move money directly from stocks into bonds. In fact, I'd suggest an intermediate step. As you're peeling back on your equity exposure, I think it's sensible to move the money into cash and/or short-duration bonds (duration is a measure of interest-rate sensitivity), then slowly and systematically dribble it into the bond market over a period of several months or even years. In so doing, you'll reduce the odds of moving a lot of money into bonds at what in hindsight could prove to be an inopportune time. By dollar-cost-averaging into the bond market, you'll also be able to obtain a range of purchase prices for your new bond holdings. 

At first blush, this strategy might seem like market-timing. But true market-timing would involve moving all of your money out of bonds and into cash, then back into bonds at a later date, when you thought the coast was clear on the rate front. Implicit in such a strategy is that you know when interest rates will increase and when they will stop rising, which of course you don't. The aforementioned DCA strategy, by contrast, acknowledges that there's a lot you don't know, and leaves open the door to the idea that rates could stay low (and bonds could remain relatively attractive) for a while. Thus, you begin enlarging your bond stake immediately, albeit in small chunks, and continue doing so in stages until you've reached your target allocation.

3) Don't box yourself in.
On the surface, the prescription for worried bond investors looks simple: Shorten up duration and, because we're in the midst of at least some kind of an economic upswing, emphasize credit-sensitive bonds at the expense of more rate-sensitive ones. And investors' recent bond-fund investments appear to reflect that outlook (or maybe just an appetite for higher yields). We've seen strong inflows into credit-sensitive sectors such as high-yield and bank loans as well as multisector bond funds, which often have junky profiles.

Yet casting your lot with a single outcome carries the risk that you'll get it wrong. Moreover, adding to credit-sensitive sectors also has the effect of bumping up your portfolio's sensitivity to the equity markets, the very thing you're trying to avoid when derisking your portfolio. Because the current bond-market outlook is uncertain, one strategy I and others at Morningstar have been espousing is to make sure that the bond investments you do buy now are as flexible as they can be. By focusing on high-quality funds in the intermediate-term bond category, you're adhering to your core mission of reducing risk in your portfolio, but you're also giving yourself some leeway in case bonds hit turbulence. Flexible funds such as  PIMCO Total Return (PTTAX),  Harbor Bond (HABDX), and  Metropolitan West Total Return Bond (MWTRX) are allowed to shorten up or lengthen duration, venture overseas, or emphasize individual bond sectors as their managers see fit. Of course, such funds aren't infallible; many had short durations in 2011, which hurt their performance versus the Barclays Aggregate Bond Index. But in a rapidly changing environment, I like the idea of delegating the decision-making to a professional money management team with a lot of room to maneuver.  

4) Consider alternative sources of safety. 
As you derisk your portfolio, I think it pays to think outside the box and look beyond traditional solutions. (And no, I don't mean so-called alternative investments, which often have high costs relative to their return potential.) Think about what you're trying to achieve by transitioning your portfolio to bonds as retirement draws near. It's safety and liquidity, right? One idea for obtaining both is to take some of the money you would otherwise have earmarked for bonds and use it to pay down debt, even low-interest mortgage debt. You earn a guaranteed return on your money, which you can't achieve with even the safest bond. If having a paid-down mortgage will reduce your expenses in retirement, you will be reducing the need to raise cash in your portfolio to meet in-retirement living expenses.  

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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.