Bonds generally offer a smoother ride than stocks. Lately, many bond investors might disagree; since mid-April, the average long-term government bond fund has tumbled 5.5%, observes Richard Moroney, editor of Dow Theory Forecasts.
Blame the recent tailspin partly on the uncertain US 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 US 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, a portfolio 50% invested in the S&P 500 and 50% invested in Barclays US Aggregate Bond had a 10-year annualized standard deviation (a gauge of monthly volatility) of 7.6% for the ten 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 (THOPX), which is 85% invested in corporate bonds and yields 3.7%.
Baird Core Plus Bond (BCOSX), our top pick among intermediate-term funds, holds mostly corporate bonds and mortgage-backed securities. It yields roughly 2.1%. Both funds are members of our recommended fund portfolios.
For bond investors who favor exchange-traded funds, we recommend Vanguard Short-Term Corporate Bond (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 (BIV), which yields 2.3%.
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