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Should You Add Flavor to a Vanilla Bond Portfolio?

Christine Benz discusses what to think about when it comes to diversifying your bonds.

Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Should your bond portfolio stay bland and boring? Or does it ever make sense to venture into some of the more specialized or even exotic types of bonds? Joining me to discuss that topic is Morningstar's director of personal finance, Christine Benz.

Christine, thank you for joining us today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, before we start talking about some of these more narrowly focused categories, let's take a step back and talk about what are some of the type of bond funds that investors should consider as more of the core of their portfolios?

Benz: I think a core starting point for investors adding fixed-income exposure to their portfolios would be to think about the short- and intermediate-term core bond categories. So, the idea there is that you are getting pretty low returns--and it will ebb and flow based on the time period--not great returns, but you're getting great stabilization for your portfolio. If the idea is that you're getting closer to needing your money for spending, which is why most people own bonds, that you want to keep things pretty bland and boring, and short and intermediate-term bonds tend to deliver--they tend to perform well in periods when equities are falling, which is what you want from your bond portfolio.

Dziubinski: Now, let's assume I have those bases covered. I have my short-term needs covered; I have the intermediate-term bond portion of my portfolio. Should I ever venture out beyond that into any of these specialized categories?

Benz: One of the key categories that comes to mind would be Treasury Inflation-Protected Securities. So, a key thing to know about bonds in general is that inflation is the natural enemy. It's your natural enemy as a bond investor, because it eats away at the purchasing power of the interest that you earn from that bond. And so, Treasury Inflation-Protected Securities nicely address that problem by offering a little bit of a bump up in your principal value when inflation is running up. Recently, inflation hasn't been anything to worry about. But I think that it's worth keeping in the back of your mind because you don't know when inflation will flare up. It's really hard to predict. So, I think that this is an interesting sort of secondary category to consider. You definitely want to hold them within the confines of a tax-sheltered account because they are taxable bonds and plus that inflation adjustment that you receive is also taxable.

Dziubinski: So, do all bond investors, should they all be considering TIPS funds?

Benz: Well, it's interesting. When I look at the allocations that our colleagues in Morningstar Investment Management put together, they really only start getting interested in TIPS, Treasury Inflation-Protected Securities, for people getting close to or in retirement, that the allocation start building there for a couple of reasons. One is that if you're in retirement, you're not earning that paycheck from your job anymore. So, you're not eligible for those COLA adjustments that you are getting when you were working. You may get an adjustment in your Social Security income. But the part of your portfolio that you're withdrawing for your living expenses--that's not getting inflation-adjusted to the extent that it's in bonds. So, you'd want to think about it, especially as you're getting close to or certainly in retirement. If you're still earning a paycheck and you're owning bonds mainly to provide diversification for your total portfolio, there's less of a reason to own TIPS.

Dziubinski: Makes sense. Christine, what about international exposure? When we talk about the equity portion of our portfolios, we often talk about adding some international exposure for diversification. What about with fixed income? Should we be thinking about it the same way?

Benz: Well, it's a controversial topic. And I guess a key point I would make in the realm of bond funds is that international-bond funds are really broad basket. So, you have some very safe products where they're hedging the foreign-currency exposure into the dollar. And what you get is a performance pattern that's quite similar to what you might get with a U.S. short- or intermediate-term bond fund except you're maybe getting some different interest-rate exposures. But there are also some very aggressive products that fall under the international bond umbrella, some that might be unhedged in terms of their currency exposure. So, they might incorporate a lot more fluctuations associated with foreign currencies. My bias would be more toward the very safe set of funds, the ones that do hedge their foreign-currency exposure. I would say for investors who want to diversify and they are owning international bonds mainly to be stabilizers and diversifiers for their portfolio, they probably want to concentrate their attentions there.

Dziubinski: The types of funds we've been talking about, in general, tend to favor higher-quality securities.

Benz: Yes.

Dziubinski: Should investors be thinking about going down their credit-quality ladder with floating-rate loans, or high-yield bond funds? And what should they be thinking about if they do choose to do that?

Benz: Yeah, certainly, yields are much more tantalizing in that area. The thing is, though, these products tend to be pretty volatile. We've been talking about products that exhibit equitylike characteristics. And I would say, many of these products do exhibit sort of hybrid performance. Maybe they're not quite as volatile as equities, but directionally they're similar. And we saw that during the financial crisis as well, where, even though junk bonds and floating-rate loans didn't lose quite as much as the S&P 500 when stocks were down, directionally they moved in sympathy. So, you want to keep that in mind that there's a trade-off. Even though yields are higher, you are picking up more sensitivity to the equity market. You're picking up more sensitivity to what's going on in the economic cycle. So, I think of them as very supporting players. I think of them, kind of, in the realm of small growth in your equity portfolio. This is sort of the aggressive kicker component of your fixed-income portfolio.

Dziubinski: Interesting. Great things for us to think about when it comes to diversifying our bonds. Thank you, Christine, for joining us today.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for tuning in.