Bond funds overlooked
NEW YORK – It’s hard to get worked up about bond mutual funds when interest rates are rising, but most financial planners will tell you that no matter what the economy is doing or where rates are headed, a portion of your portfolio should be devoted to fixed income.
Even the youngest investors, or those convinced they have years of saving ahead, should allocate at least 10 percent of their portfolios to bonds, because it will help reduce volatility when stocks hit the skids. Older investors, or those with shorter time horizons, should consider putting a higher percentage in fixed income, financial planners say.
“Bonds tend to be the stepchildren of the financial services universe; they’re totally overlooked by people focused on growth and price appreciation,” said Lynnette Khalfani, a money coach in West Orange, N.J., and the author of two personal finance books. “But you always have to be mindful, in certain environments when stocks act poorly, bonds can act as a hedge.”
This was made abundantly clear when the technology bubble burst. In 1999, when the average stock fund was returning upward of 15 percent to 20 percent, many investors found the slow and steady returns of bond funds too dull to bother with, said Scott Berry, an analyst with fund tracker Morningstar Inc.
“Our phone never rang,” Berry recalls. “Bond funds were completely ignored for being too boring, or too safe. They just weren’t offering much in the way of return. Then in 2000, we saw the stock market crater, and we saw bond fund returns really spike up.”
The Vanguard Total Bond Market Index gained 11.4 percent in 2000, another 8.4 percent in 2001, and 8.3 percent in 2002. By comparison, the Vanguard 500 Index, which tracks the Standard & Poor’s 500 index of widely held large-cap stocks, slid 9.1 percent in 2000, fell another 12 percent in 2001 and sank 22.2 percent in 2002.
To the relief of stock investors, banner years for bonds don’t come around too often. And while bonds do see lean times, current returns are quite reasonable compared to 1999, when the Vanguard Total Bond Market Index registered a dismal 0.8 percent decline.
Rather than holding bonds individually, which can be quite an expensive way to build a diversified portfolio, the average investor’s fixed income needs are best served by bond mutual funds.
Good core bond funds will hold everything from investment grade government and corporate bonds to mortgage-backed securities and asset-backed securities, such as credit card, auto and home equity loans. Most will have some foreign exposure; a few might include emerging market debt or junk bonds – lower-rated corporate debt that pays a higher yield because it carries a greater risk of default.
Core funds will also hold bonds of varying ranges of maturity. A diversified portfolio will use a ladder strategy to stagger them, meaning the fund manager will hold some short-term, some medium-term and some long-term bonds, to reduce interest rate risk.
Because the differences in the rates of return delivered by core bond funds tend to be slight, expenses are a big factor.
Whether you choose a passively managed index fund or an actively managed portfolio, you should be able to find one with an expense ratio of less than 1 percent, Berry said.