Want Bonds? Go With Funds

5/18/2015


Bonds generally offer a smoother ride than stocks. Lately, many bond investors might disagree.

Since April 13, the average long-term government bond fund has tumbled 5.5%. Barclays U.S. Aggregate Bond Index, which tracks a wide spectrum of investment-grade corporate and government bonds, has retreated 1.3%. In contrast, the S&P 500 Index is up slightly.

Blame the recent tailspin partly on the uncertain U.S. economy, which is complicating the Federal Reserve's plans to raise interest rates. In addition, a modest rebound in inflation expectations, spurred partly by a rebound in oil prices, has weighed on bonds. Finally, European bond markets have tumbled, helping drag down U.S. fixed-income securities.

Investors seeking the dependability of bonds might be dismayed, but bonds can still play a key role in helping diversify a portfolio. Consider the table below, which shows risk and return characteristics for five portfolios invested in varying amounts of stocks and bonds.

BONDS OFFER DIVERSIFICATION BENEFITS
Adding bonds to an all-stock portfolio reduces standard deviation (volatility) and the potential for losses. Data is based on monthly index returns ending April.
Portfolio Allocation
------ Annualized Returns ------
Annualized
Standard
Deviation
(10 Yrs.)
(%)
----- Last 10 Years -----
S&P 500
Index
(%)
Barclays U.S.
Aggregate
Bond Index
(%)
3
Years
(%)
5
Years
(%)
10
Years
(%)
Best 12
Months
(%)
Worst 12
Months
(%)
100
0
16.7
14.3
8.3
14.7
53.6
(43.3)
75
25
13.2
11.9
7.7
11.1
41.4
(33.9)
50
50
9.6
9.4
6.8
7.6
30.0
(23.3)
25
75
6.1
6.8
5.9
4.5
19.3
(11.3)
0
100
2.6
4.1
4.8
3.3
13.8
(2.5)

For example, a portfolio 50% invested in the S&P 500 and 50% invested in Barclays U.S. Aggregate Bond had a 10-year annualized standard deviation (a gauge of monthly volatility) of 7.6% for the 10 years ended April. Based on its annualized return of 6.8%, you would expect a yearly return between a gain of 14% and a loss of less than 1% about two-thirds of the time. For comparison, a portfolio invested only in the S&P 500 has a 10-year standard deviation of 14.7% and return of 8.3%, putting the range of likely returns between 23% and a loss of 6%.

How much should you hold in bonds? The answer largely depends on your risk tolerance and time horizon. Our recommended Growth Portfolio — with about 18% in bonds/cash and 82% stocks — is geared toward long-term investors. The Conservative Portfolio — roughly 26% bonds/cash and 74% stocks — is for investors with a shorter time horizon.

Most investors should focus on short- and intermediate-term funds, as funds holding long-term bonds face the most interest-rate risk.

Our favorite short-term fund is Thompson Bond ($12; THOPX), which is 85% invested in corporate bonds and yields 3.7%. Baird Core Plus Bond ($12; BCOSX), our top pick among intermediate-term funds, holds mostly corporate bonds and mortgage-backed securities. It yields roughly 2.1%. Both funds earn ranks above 80 and are members of our recommended fund portfolios.

For bond investors who favor exchange-trades funds (ETFs), we recommend Vanguard Short-Term Corporate Bond ($80; VCSH), which yields 1.6%. Investors seeking higher income and who are willing to take on slightly more risk should consider Vanguard Intermediate-Term Bond ($85; BIV), which yields 2.3%.

OUR RECOMMENDED MUTUAL FUNDS
Year-To-Date *
--- % Of Portfolio ---
 
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating †
Artisan International ($32; ARTIX)
5.7
E
9
9
91
Baird Core Plus Bond ($12; BCOSX)
0.4
B
9
4
94
Dreyfus Midcap Index ($39; PESPX)
4.96
B
0
0
50
Dreyfus Small Cap Stock Index
($30; DISSX)
2.5
C
0
0
81
Homestead Small Company
($40; HSCSX)
0.6
E
5
6
85
iShares MSCI EAFE Small-Cap ETF
($53; SCZ)
12.3
C
4
6
83
T. Rowe Price Divers. Small-Cap Growth
($27; PRDSX)
7.2
A
7
7
100
T. Rowe Price Value
($36; TRVLX)
2.7
A
10
11
93
Thompson Bond ($12; THOPX)
1.9
A
9
4
81
Vanguard 500 Index ($194; VFINX)
2.6
C
7
8
84
Vanguard Dividend Growth
($23; VDIGX)
1.7
D
10
10
56
Vanguard GNMA ($11; VFIIX)
0.6
B
0
0
98
Vanguard Growth Index
($56; VIGRX)
4.2
C
10
11
86
Vanguard High-Yield Corp. ($6; VWEHX)
2.7
E
5
6
94
Vanguard Inter.-Term Tax-Exempt
($14; VWITX)
(0.2)
D
0
0
88
Vanguard Selected Value
($30; VASVX)
4.0
B
5
8
88
Vanguard Short-Term Invest.-Grade
($11; VFSTX)
1.0
B
0
0
100
Vanguard Total Bond Mkt. Index
($11; VBMFX)
0.2
D
0
0
44
Vanguard Wellesley Income
($26; VWINX)
1.1
E
0
0
98
Vanguard Wellington ($40; VWELX)
1.9
D
10
10
98

* Year-to-date ranks through May 12from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%;
E = bottom 20%. † Fund ratings are percentile ranks based on our fund-rating system.


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