The Role of Bond Funds for Mutual Fund Portfolios

by

Jack Piazza
Sensible Investment Strategies

Investors frequently ask the following questions about bond funds: what type of bond funds should I consider, what are the varying degrees of risk between the different type of funds, how does this risk relate to my personal risk tolerance and what percentage of bond funds should I allocate to my overall portfolio?

Bond funds provide two primary functions: (1) generating income and (2) reducing overall portfolio volatility. The amount of interest income (yield) from bond funds is dependant upon several risk factors, including credit rating of the securities, average maturity of the holdings, interest rate fluctuation and - in foreign bonds - currency fluctuation and degree of political stability. A secondary function of certain bond funds is capital appreciation potential.

Credit ratings refer to the degree of safety of the bond fund issuers to repay debts. The highest rated bonds (AAA, then descend in safety to AA, A and BBB) are considered investment-grade. Bonds rated BB, B, CCC, CC, and C are below investment-grade. Bonds rated D are in default. Lower-rated bonds have higher yields to compensate investors for incurring additional credit risk.

Average maturity is classified as either short-term (1-3 years), intermediate-term (4-10 years) or long-term (over 10 years). Interest rate fluctuation: short-term maturities with the highest credit ratings will have the lowest interest rate volatility; as maturities lengthen and/or credit ratings decrease, interest rate volatility rises.

Lets examine some of the different types of bond funds:

• Government - invests primarily in U.S. government treasury notes and bonds and, to a lesser extent, other U.S. government agency obligations. Short-term maturities offer the highest safety of principal with comparatively low income; longer government maturities will offer higher interest rates and will exhibit more volatility in both yield and price. 
• TIPS (Inflation-Protected Securities) - invests in high-quality inflation-indexed bonds issued by the U.S. Treasury and government agencies. TIPS typically have lower actual yields than conventional fixed-rate bonds due to their CPI inflation adjustment feature for principal. Anticipated deflation or stagflation are noteworthy risks for TIPS.
• Government Mortgage - invests in mortgage-backed securities by the Government National Mortgage Association (GNMA). Yield is higher than other immediate-term government securities.
• Municipal - invests primarily in investment-grade municipal securities which can be national or state-specific. Objective is income that is exempt from federal income tax; state income tax from its state-specific fund is also exempt. High-yield municipals invest in lower investment-grade municipals and offer higher income with higher risk.
• Corporate - invests primarily in investment-grade debt obligations of U.S. corporations. Both the yield and volatility for short, intermediate and long-term corporate bonds will be greater than similar maturities for government securities. Total return potential (income and capital gain) is also greater than government bonds with similar maturities. Some corporate bond funds will also invest in government bonds.
• Diversified International - invests in primarily high-quality bonds of foreign countries, although a portion of holdings (up to 15-25%) may be in lower-quality bonds. Currency fluctuation is an additional risk factor. Above-average current income and capital appreciation are objectives.
• Global or World - combines the characteristics of the aforementioned corporate and diversified international bond funds in any maturity. Above-average income and capital appreciation are objectives.
• Multisector - invests in several diversified bond sectors, including U.S. government, TIPS, mortgage-related securities, corporate, diversified international, high-yield and emerging markets in any allocation combination and maturity. The average maturity for this type of fund is normally intermediate-term. Objectives are above-average income and capital appreciation. A multisector bond fund is ideal for investors who desire either just one bond fund or a core bond fund for a portfolio. However, due to the variance of risk among multisector bond funds, investors should examine the percentage difference between investment-grade and below investment-grade holdings for risk tolerance suitability.
• Bank Loan - invests in very short-term (30-90 day) senior debt obligations that banks or other financial institutions lend to businesses. Also known and marketed as floating rate loans, the interest rate to borrowers usually resets monthly. These type of bond funds are normally rated below investment-grade with high yield as an objective.
• High-Yield - invests primarily in below investment-grade bonds (rated BB and below), including some foreign debt; many high-yield funds also can invest 10-20% of their assets in income-producing convertible securities and preferred stocks. The risk in high-yield bond funds varies from above-average to very high, depending upon the percentage of holdings rated below CC. Most funds in this category have intermediate-term maturities. Objectives are high income and capital appreciation.
• Emerging Markets - invests in government and corporate securities of emerging markets countries. These securities are typically rated below investment-grade due to the issuing countries being economically underdeveloped. The typical average maturity is intermediate-term. Currency fluctuation and political stability pose additional investor risks. Objective is high income and high capital appreciation.

 Bond Allocation Guidelines 

The fundamentals of effective diversification - the spreading of assets over diverse and distinct fund categories to achieve (1) specific risk/reward objectives and (2) a reduction of overall portfolio risk - should remain the cornerstone of any investment strategy. The choices for bond fund types and allocation are basically dependent upon (1) an overall growth, balanced or income-oriented return objective, (2) portfolio size and (3) individual risk tolerance.

The size of one's portfolio will determine the number of bond funds: the larger the portfolio, then  increases in the number of different types of bond funds can provide greater diversification.

Risk tolerance is a significant factor in the selection of the different types and credit ratings of bond funds: conservative risk tolerances will accept lower yields and lower total return to minimize volatility; moderate, or average, risk tolerances will accept greater volatility than conservative risk tolerances to pursue higher yields and higher total return; aggressive risk tolerances will accept even greater swings in volatility to seek the highest yields and highest total return. In portfolios with a long-term time horizon (over 5 years), any of these three risk tolerances can combine with a growth, balanced or income-oriented return objective.

 Bond Allocation Suggestions 

Bond allocation percentage is directly related to investor  stages of accumulation and withdrawal. Generally, as investors advance from one accumulation stage to the withdrawal stage (retirement), investors should increase bond fund allocations. Below are four long-term, investment stage scenarios, each with aggressive, moderate and conservative risk tolerances:

• 25+ years to retirement - 10-20% total bond allocation for growth-oriented strategies. Normally, one multisector bond fund would suffice or one could add an additional bond fund.
      Aggressive - 10-15% bond allocation: 10-15% multisector, Option: add 5% high-yield.
      Moderate - 20% bond allocation: 15% multisector, 5% intermediate-term corporate.
      Conservative - 20% bond allocation: 10% multisector, 10% intermediate-term         government.
   

• 11-25 years to retirement - 25-35% total bond allocation for growth-oriented strategies.
      Aggressive - 25% bond allocation: 15% multisector, 5% high-yield, 5% emerging markets.
      Moderate - 35% bond allocation: 20% multisector, 15% intermediate-term corporate, 10% diversified international.
      Conservative - 35% bond allocation: 15% multisector, 10% intermediate-term government, 10%intermediate-term corporate.
   

• 1-10 years to retirement - 50% total bond allocation for balanced-oriented strategies.
      Aggressive - 50% bond allocation: 30% multisector, 15% high-yield, 5% emerging markets. Option: change to 10% high-yield, add 5% diversified international.
      Moderate - 50% bond allocation: 25% multisector, 15% intermediate-term corporate, 10% diversified international. Option: change to 5% diversified international, add 5% high-yield.
      Conservative - 50% bond allocation: 20% multisector, 15% intermediate-term government, 15%intermediate-term  corporate. Option: change to 10% intermediate-term corporate, add 5% government mortgage.
   

• Retirement - 70% total bond allocation for income-oriented strategies.
      Aggressive - 70% bond allocation: 35% multisector, 15% high-yield, 10% emerging markets, 5% short-term  government. Option: change to 5% emerging markets, add 5% diversified international.
      Moderate - 70% bond allocation: 30% multisector, 20% intermediate-term corporate, 15% diversified international, 5% short-term government. Option: change to 10% diversified international, add 5% high-yield.
      Conservative - 70% bond allocation:- 25% multisector, 20% intermediate-term government, 20%intermediate-term corporate, 5% short-term government. Option: change to 15% intermediate-term corporate, add 5% government mortgage.

Reminder: A growth, balanced or income-oriented strategy can be applied for any of the above long-term scenarios. For example, some investors may prefer to use a balance-oriented strategy in retirement, which would be a 50% bond allocation with either aggressive, moderate or conservative risk tolerances.

Investors should realistically evaluate their tolerance for risk on a regular basis. In my opinion, many investors initially take overly excessive risk, only to realize their mistake when significant negative losses occur. Be deliberate and realistic when assessing your individual risk tolerance. If a sizable loss would adversely affect your long-term viewpoint, then (1) descend to the next lower level of risk tolerance and (2) select less volatile bond fund categories.

Finally, once an investor has chosen the appropriate bond fund categories, the next step involves selecting specific funds. Select no-load funds with above-average category performance, objective and style adherence, preferably long-tenured management and average to below-average operating expenses for each particular bond fund category.

Related articles: Portfolio Changes in Retirement  The Role of Risk in Mutual Fund Strategies