The Best Types of Bond Funds for the Core of a Portfolio

After enduring a tough year for bonds in 2022 and facing a still-high interest-rate environment in 2023, many investors may be reconsidering the fixed-income allocations of their investment portfolios. We talked with Morningstar portfolio strategist Amy Arnott about her new research, Morningstar’s Role in Portfolio Framework, and which types of bond funds are best for the core of most investors’ portfolios.

Susan Dziubinski: Your comprehensive new research examined, among other factors, the frequency of losses, maximum time to recovery, and dispersion of returns among fund categories across asset classes. From that, you built guidelines investors can use to determine what roles various types of funds can and should play in their portfolios. You came up with four basic roles. What are they, and how much of their portfolios should investors keep in each “role”?

Amy Arnott: The first role is main/stand-alone funds, which are broadly diversified across asset classes. We consider them suitable either as the main holding in a portfolio (consuming 80% to 100% of assets) or as the only holding in a portfolio. The only fund categories that land in this group are diversified by asset class, including most of the allocation and target-date Morningstar Categories.

The next level down is core funds, which are broadly diversified across a major asset class, such as large-cap stocks or investment-grade bonds. We consider core funds suitable for an allocation as large as 40% to 80% of the total portfolio.

Then there are building-block funds, which focus on medium-size areas of the market, generally one degree removed from a major asset class. For example, we include large-growth and large-value funds in the building-block group. As the name implies, investors can use these funds as components to put together diversified portfolios. We consider 15% to 40% to be an appropriate weighting range for a building-block fund.

Finally, the lowest tier is limited funds, which focus on more specialized parts of the market and/or areas that are difficult to use in a portfolio. Our framework recommends allocating no more than 15% of assets to a given fund in this group.

Dziubinski: You suggest that the core holdings of an investor’s portfolio should consume about 40% to 80% of a total portfolio. But how should investors be thinking about their bond allocations overall? Put another way, how much of an investor’s total portfolio should be held in bonds, and how do investors then layer your Role in Portfolio research on top of that?

Arnott: There’s an old rule of thumb that your equity allocation should be 100 minus your age; for example, a 30-year-old investor would have 70% in stocks. You can flip that around (meaning your age would be the target bond allocation) to get a reasonable allocation to bonds.

The average bond allocation for target-date funds, which are all-in-one funds that automatically adjust their asset mix based on the investor’s age, is another reasonable starting point. A typical target-date portfolio allocates about 8% to bonds for an investor at age 25, gradually increasing to 55% at age 65 and then up to 66% by age 95.

Personally, I think these allocations are on the conservative side. Some investors might want to take on a bit more equity exposure if they’re able to tolerate the risk.

Dziubinski: What types of bond funds are the best choices for the core of a portfolio?

Arnott: If you only own one taxable-bond fund, I’d focus on a mainstream bond category, such as intermediate core bond, rather than more specialized areas like high-yield bonds. Funds in the intermediate core bond category typically provide the broadest exposure to the overall bond market. If you have a shorter time horizon, you might want to go with a short-term bond or ultrashort bond fund.

Dziubinski: It’s surprising that multisector bond funds and nontraditional bond funds aren’t considered core bond holdings while intermediate core-plus bond funds are considered core bond holdings. After all, the funds in all three of those categories typically invest in a variety of different types of bonds. Explain the differences among those bond-fund categories, and why the intermediate-term core-plus bond category is the only one of the three that lands in the core portion of your Role in Portfolio rubric.

Arnott: Multisector bond funds and nontraditional bond funds boast higher SEC yields (currently 5.74% and 5.72%, respectively) compared with the intermediate core-plus category, which has an average SEC yield of 4.47%. To grab extra yield, funds in both categories take on more risk. Multisector bond funds typically hold 35% to 65% of their assets in securities that are either unrated or rated BB or below. Nontraditional bond funds have more flexibility to make active interest-rate bets, take both long and short positions, and typically don’t have many constraints on their exposure to credit, sectors, currency, or interest-rate sensitivity.

Intermediate core-plus bond funds, on the other hand, generally stick with investment-grade credits and don’t have as much exposure to esoteric areas of the bond market as the other two categories. In most market environments, they’ve also had less downside risk. We consider intermediate core-plus bond funds more representative of the bond market overall and more suitable as core holdings.

Dziubinski: Why might investors venture out beyond core bond fund types in their portfolios?

Arnott: People often venture into riskier types of bond funds to boost yield. Before interest rates started their upward climb, for example, high-yield bond funds boasted a bigger yield advantage compared with more mainstream bond-fund categories.

Now that interest rates are so much higher, there’s not as much need to take on additional credit risk to boost yield. Because the main reason for owning bonds is to reduce risk, I like to keep my bond holdings simple and straightforward rather than reaching for yield or the highest possible returns.