Bonds Can Help Smooth a Rocky Investment Path

The power of bonds to smooth stock-market risk over time is often lost on investors. Stocks' inherent volatility doesn't really bother most shareholders — as long as prices go up. But those sharp market downturns are painful reminders that stocks follow a rocky trail.

Bonds can pave the path, yet since market conditions can change literally overnight, fixed-income investments should be in your portfolio before the unexpected occurs. And if market history is a guide, many people might have an easier time staying fully invested during turbulent periods if they kept a lot more money in bonds.

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"All it takes is one negative event," said Jim Peterson, a vice president at the Schwab Center for Investment Research. "People think they'll have time to move their allocation around, but markets move extremely quickly. Fixed income provides protection."

"High-quality bonds hold up well; they give you a good return most of the time, and they're very simple," added Russel Kinnel, director of mutual-fund research at investment researcher Morningstar Inc.

In particular, high-quality bonds and mutual funds that invest in them can diversify a portfolio cheaply and effectively, without fancy — and expensive — techniques such as long-short trading strategies and other stock-hedging tactics.

Moreover, adding bonds to an all-stock portfolio cuts downside risk considerably but forfeits only a small portion of potential gain.

Boosting bond exposure

How much to invest in bonds? For risk control, more is better.

Schwab research shows that a portfolio of 90 percent Standard & Poor's 500 Index (SPX) stocks and 10 percent intermediate U.S. government bonds would have produced a 10.9 percent annualized average gain from 1970 to 2005. But that aggressive portfolio in its worst year tumbled 23.3 percent.

In contrast, a temperate 50-50 stock-bond blend would have returned 10 percent over that period, but fell 10.4 percent in its worst year.

Research from investment-data firm Ibbotson Associates Inc., a unit of Morningstar, shows a mix of 75 percent S&P 500 stocks, 20 percent long-term U.S. government bonds and 5 percent cash gaining 9 percent annually on average over 10 years through December 2005. Meanwhile, a mirror image of 75 percent bonds, 20 percent stocks and 5 percent cash would have gained 8.1 percent.

In that time — a relatively brief study period when both U.S. stocks and bonds fared well — a $10,000 investment in the high-stock portfolio grew to about $24,000; the high-bond portfolio was worth about $21,000.

"There's a sweet spot," in the stock-bond allocation debate, Schwab's Peterson said. "Not a lot of people realize that the optimal risk-return trade off is more in the moderate space."

Taking stock of bonds

For many financial advisers, however, that "sweet spot" for bonds leaves a bitter taste.

"I would highly recommend that people not have a portfolio of mostly bonds," said Kacy Gott, a principal at San Francisco-based investment manager Kochis Fitz. "There's not enough growth potential to keep up with inflation over longer periods."

Even investors in their mid-50s and nearing retirement should lean toward stocks, Gott said, because they'll need equities' inflation-fighting strength to lessen inflation's bite. "They've still got 40 years of their life in front of them," he said. "Living expenses will double, perhaps triple." A bond-heavy portfolio "will be fine to start with," Gott added, "but each year will get a little bit tighter."

Highly risk-averse investors might be tempted to keep most or all of their money in bonds and cash, but Barbara Steinmetz, a Burlingame, Calif., financial adviser, warns against being "hung up on income" over a long time horizon.

"The principal may be intact, but the principal's purchasing power is not," she said. "A portfolio needs a growth side as well."

Even bond experts advise against going to extremes. "We bond people don't believe you should have bonds all the time; you need a combination," said Marilyn Cohen, president of Envision Capital Management Inc. in Los Angeles.

That said, many investors have too little in bonds. "Baby boomers and older people should embrace some type of fixed income, something to offset the volatility and unpredictability of the equity market," Cohen said.

Owning bonds directly gives you the comfort of knowing how much you'll have when the bonds mature and the income you can count on over that period. Bond prices slip when interest rates climb and rise when rates fall, but holding your investment to maturity negates that issue.

Cohen said there are bargains now in short-term U.S. government agency bonds issued by the Federal Home Loan Banks and the Federal Farm Credit Banks, which she points out are not to be confused with Freddie Mac or the Federal Agricultural Mortgage Corporation (Farmer Mac).

To combat inflation, she added, look to U.S. Treasury Inflation Protected Securities, or TIPS, as well as Series I savings bonds, or "I-bonds," and inflation-linked corporate bonds.

Tax-free municipal bonds are also attractive income sources, Cohen said. "Munis are a great buy," she said. For the maximum tax advantage, look to munis in your home state, which can be free from local, state and federal taxes, Cohen added.

Fund facts

Bond funds differ from owning bonds outright, largely because funds have no maturity date. Funds do offer individual investors diversification, generally for a low investment minimum, and their professional management is crucial when navigating this opaque marketplace. Bond funds also hold more appeal now that rising interest rates have boosted yields.

"You're getting paid more and bonds have come back to more reasonable levels," said Morningstar's Kinnel. "For awhile you weren't getting paid well for the risk you were taking."

Keep in mind that expenses can eat away at bond funds' total return. Fortunately, many highly regarded funds operate at low cost, so "you can keep just about all of that return for yourself," Kinnel said.

Topping Kinnel's recommend list are offerings from Pacific Investment Management Co., or Pimco, and fund giants Vanguard Group and Fidelity Investments.

Vanguard is particularly stingy about fees, Kinnel said. Good options, he added, include Vanguard Inflation Protected Securities Fund (VIPSX) , Vanguard Total Bond Index Fund (VBMFX) and Vanguard Intermediate-Term Tax Exempt Fund (VWITX) . And Fidelity's municipal bond funds are "hard to go wrong with," Kinnel added, although the appropriate option depends on where you live.

Individual investors can take advantage of Pimco's institutionally focused bond expertise, Kinnel said, through the reasonably priced Harbor Bond Fund (HABDX) , a diversified portfolio in the charge of bond guru Bill Gross, and sibling Harbor Real Return Fund (HARRX) , which invests mostly in TIPS.

"When you get these low-cost bond funds, it's just great because all this income is flowing to you," Kinnel said. "It's not get-rich quick, but it's a respectable yield. At times like this, that can really be rewarding."

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